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PROPERTY RIGHTS THEORY AND OWNERSHIP OF FIRM-SPECIFIC ADVANTAGES: THE IMPLICATIONS OF CONTRACTING AND LICENSING WITHIN THE MULTINATIONAL FIRM by Catherine Magelssen A Dissertation submitted to the Graduate School-Newark Rutgers, The State University of New Jersey in partial fulfillment of the requirements For the degree of Doctor of Philosophy Graduate Program in Management written under the direction of Susan Feinberg and approved by ____________________________ ____________________________ ____________________________ ____________________________ Newark, New Jersey October, 2014

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Page 1: PROPERTY RIGHTS THEORY AND OWNERSHIP OF FIRM …

PROPERTY RIGHTS THEORY AND OWNERSHIP OF FIRM-SPECIFIC

ADVANTAGES: THE IMPLICATIONS OF CONTRACTING AND LICENSING

WITHIN THE MULTINATIONAL FIRM

by

Catherine Magelssen

A Dissertation submitted to the Graduate School-Newark

Rutgers, The State University of New Jersey

in partial fulfillment of the requirements

For the degree of

Doctor of Philosophy

Graduate Program in Management

written under the direction of

Susan Feinberg

and approved by

____________________________

____________________________

____________________________

____________________________

Newark, New Jersey

October, 2014

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© 2014

Catherine Magelssen

ALL RIGHTS RESERVED

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ABSTRACT OF THE DISSERTATION

Property Rights Theory and Ownership of Firm-Specific Advantages: The

Implications of Contracting and Licensing within the Multinational Firm

By Catherine Magelssen

Dissertation Director:

Professor Susan Feinberg

Firm-specific advantages (FSAs) play a critical role in the theory of the

multinational firm. Firms establish foreign operations when their FSAs are not suitable

to outsource or license in the market. However, the same assets deemed unsuitable for

external contracting and licensing are extensively contracted and licensed within the

multinational firm. The parent and/or subsidiaries that are the economic owners of the

assets contract other entities within the firm to perform activities such as R&D,

manufacturing, and distribution and pay them a guaranteed return for their activities.

Internal ownership of FSAs has implications on the risks borne, incentives, resource

allocation, and power distribution within the firm. Using a unique, confidential dataset

on the internal transactions of multinational firms, including intra-firm product flows,

economic ownership of FSAs, financials, and detailed specifications of the activities of

subsidiaries within the firm, I examine the determinants of the structure of economic

ownership of FSAs as well as the impact of FSA ownership on innovation within the

multinational firm.

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Dedication

To my husband, Hans, and to my family. Thank you for your love,

encouragement, help, and support.

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Acknowledgements

I would like to express my sincere gratitude to my dissertation chair, Susan

Feinberg for her constructive advice, persistence, and support. I am also grateful for my

dissertation committee members Fariborz Damanpour, Michelle Gittelman, and Tom

Prusa. They provided invaluable advice and feedback and were a continuous source of

encouragement. I would like to acknowledge Xavier Martin and Rajneesh Narula, who

provided comments at the AIB doctoral consortium, and the participants at seminars for

their thoughtful suggestions. I am grateful for all of the friends that I have met in the

doctoral program, and appreciate their encouragement and feedback. I would also like to

express my thankfulness towards Rutgers Business School for its financial support.

I am deeply indebted to the consulting firm and experts, whose support made this

dissertation possible.

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Table of Contents

1. Introduction ................................................................................................ 1

2. Theoretical Background ............................................................................. 6

FSAs and the MNC .................................................................................... 6 2.1

Property Rights Theory and the Firm ......................................................... 7 2.2

3. Data .......................................................................................................... 16

Coding of Data ......................................................................................... 18 3.1

FSA Ownership Structures ....................................................................... 22 3.2

MNC Entity-Level Data ........................................................................... 36 3.3

Summary .................................................................................................. 41 3.4

4. Inside the MNC: Structuring Ownership of Firm-Specific Advantages . 42

Introduction .............................................................................................. 43 4.1

FSAs and FSA Ownership Structures ...................................................... 48 4.2

Theoretical Background ........................................................................... 50 4.3

Hypotheses ............................................................................................... 57 4.4

Methods .................................................................................................... 59 4.5

Results ...................................................................................................... 70 4.6

Discussion ................................................................................................ 80 4.7

5. Subsidiary Ownership of FSAs and Innovation ....................................... 88

Introduction .............................................................................................. 88 5.1

Contextual Background ............................................................................ 93 5.2

Theoretical Background ........................................................................... 96 5.3

Hypotheses ............................................................................................... 99 5.4

Methods .................................................................................................. 104 5.5

Results .................................................................................................... 116 5.6

Discussion .............................................................................................. 124 5.7

6. References .............................................................................................. 128

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List of Tables

Table 1: Coding of FSAs .................................................................................................. 19

Table 2: Coding of FSA Ownership Structures ................................................................ 24

Table 3: Mean MNC Characteristics and FSAs by FSA Ownership Structure ................ 35

Table 4: Subsidiary Descriptive Statistics by Country ..................................................... 37

Table 5: Mean Value of Subsidiary Characteristics by FSA Ownership Type ................ 40

Table 6: Characteristics of FSA Ownership Structures .................................................... 49

Table 7: FSA Contractibility ............................................................................................. 57

Table 8: Contractibility Dimension Word Counts ............................................................ 65

Table 9: Mean MNC Characteristics and FSAs by FSA Ownership Structure ................ 70

Table 10: Descriptive Statistics and Correlations ............................................................. 71

Table 11: Probit and Bivariate Probit Results Predicting Shared FSA Ownership .......... 75

Table 12: Multinomial Logit Results ................................................................................ 78

Table 13: Breakout of FSA Ownership by Subsidiary Type ............................................ 94

Table 14: Balancing Test for Propensity Score Matched Sample .................................. 113

Table 15: Balancing Test for Change in FSA Ownership Matched Sample .................. 115

Table 16: Descriptive Statistics and Correlations for Initial Conditions Analysis ......... 116

Table 17: Descriptive Statistics and Correlations for Propensity Score Analysis .......... 117

Table 18: Subsidiary FSA Ownership Change ............................................................... 118

Table 19: Random Effects Negative Binomial Results .................................................. 120

Table 20: Results for Transferring Ownership of FSAs Away from Subsidiary ............ 123

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List of Figures

Figure 1: Example of FSA Ownership and Contracting and Licensing Arrangements .... 10

Figure 2: Types of FSAs ................................................................................................... 21

Figure 3: Sole Ownership Structure .................................................................................. 25

Figure 4: Shared Ownership Structure .............................................................................. 27

Figure 5: Separate Ownership Structure ........................................................................... 29

Figure 6: Mixed Ownership Structure .............................................................................. 31

Figure 7: FSA Ownership Structure by Industry .............................................................. 34

Figure 8: Number of Changes in FSA Ownership by Year .............................................. 39

Figure 9: Ownership Structure by Type ............................................................................ 72

Figure 10: Percentage of FSA Types Shared vs. Separate................................................ 73

Figure 11: Average Patenting and Citations of Patents for FSA Ownership Change .... 119

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1. Introduction

The ownership of firm-specific advantages (FSA) is central to the theory of the

multinational firm (Dunning, 1977) and firms in general (Drucker, 1995; Grant, 1996;

Kogut and Zander, 1992; Penrose, 1959). FSAs, also referred to as knowledge assets and

competencies in the management literature, are the proprietary assets that provide the

firm with a competitive advantage (e.g. Rugman and Verbeke, 2001). Firms establish

foreign operations in order to capitalize on the ownership of firm-specific advantages,

which can be transferred across the firm at a relatively low cost (Hymer, 1960; Caves,

1971). Although the theory of the multinational firm (MNC) suggests that firms establish

foreign subsidiaries when their FSAs are not suitable to contract or license in foreign

markets, MNCs contract and license the same FSAs within the firm to their subsidiaries

in those same foreign markets. The parent and/or subsidiaries (entities) that own the

FSAs (FSA owners) internally contract other entities (FSA users) within the firm to

perform activities such as research and development, manufacturing, and distribution and

pay the FSA users a guaranteed return for their activities. The FSA ownership structure

has implications on the risks borne by the various affiliates, incentives, resource

allocation, and power distribution within the MNC. While many researchers have studied

the external licensing and contracting relationships of the MNC, the internal licensing

and contracting relationships amongst affiliates have thus far been unexplored. The lack

of research in this area is no doubt due to the lack of publicly available data.

This dissertation contributes to the international business literature by examining

three questions related to MNC internal FSA ownership (or simply “FSA ownership”).

First, how do MNCs internally organize ownership of their most important value-

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generating assets? Second, how do FSA characteristics affect MNC choice of FSA

ownership structure? Third, how does FSA ownership affect affiliate innovation? I also

explore the role of tax haven FSA ownership.

A natural question arises as to whether the internal structure of FSA ownership is

simply an artifact of tax avoidance. Recent U.S. Senate hearings on Apple and other

multinational companies, and U.K. Parliamentary hearings on Starbucks, Amazon, and

Google, have captured the public’s attention and highlighted the role of shifting

ownership of FSAs offshore as a means of avoiding taxes. While some companies have

tax haven affiliates that perform research and development, manufacturing, or

distribution activities, others have tax havens that are no more than a mailbox (Drucker,

2010). Clearly, tax avoidance plays a role in FSA ownership structures. However, very

little is known about MNC FSA internal ownership outside of what is reported in the

media due to alleged tax avoidance.

Transfer pricing research focuses on predicting the appropriate transfer price of

goods within a MNC (e.g. Tsay, 1999) and examines whether MNCs shift profits from

high to low tax jurisdictions (Grubert and Mutti, 1991; Grubert, 2003; Mutti and Grubert,

2008; Dischinger and Riedel, 2010). Recent research recognizes that some MNCs

engage in extensive profit shifting whereas others do not (Grubert, 2003; Overesch and

Schreiber, 2008). The research on transfer pricing examines where profits are shifted, it

does not examine the differences in MNC internal FSA ownership structures. It also fails

to examine how the ownership of FSAs influences MNC real operations.

Chapter 2 provides the theoretical background for understanding the internal

contracting and licensing of FSAs that occurs within the MNC. Consistent with resource

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and knowledge-based perspectives of the firm (e.g. Barney, 1991; Amit and Schoemaker,

1993; Grant, 1996; Kogut and Zander, 1992), the firm is viewed as a heterogeneous

bundle of assets. Firm-specific advantages are considered the most important assets for

the firm. I build on property rights theory, which assumes that a set of rights can be

attributed to each asset or resource and lays the groundwork for predictions on the

allocation of those rights to parties in an exchange relationship. The MNC has an internal

network of exchange relationships. I argue that property rights theory compliments the

resource based perspective by enabling predictions on how the rights to the MNC’s key

value generating assets are allocated across its network of subsidiaries.

Chapter 3 provides a contextual background and an overview of the data.

Particularly since the dataset is new and relatively little is known about MNC internal

ownership of FSAs, it is worth providing some descriptive statistics. To conduct my

research, I assembled a unique confidential panel dataset obtained from a consulting firm

that advises MNCs on transfer prices. My dataset consists of the intra-firm transactions

of 102 MNCs and their parent and subsidiaries in an unbalanced, panel dataset from 1997

to 2012. The dataset includes detailed data on the economic ownership of FSAs within

the firm, contracts between the FSA owners and FSA users that clearly delineate the

rights and responsibilities of each party, mergers and acquisitions (M&As), changes in

ownership structure, tax haven ownership, financials, and product flows. I combined this

data with data from Bureau Van Dijk’s Orbis database, Thomson Financial M&A

database, and United States Patent Trademark Office. I used the combined data to

construct multinational firm-level and subsidiary-level datasets. MNCs vary by whether

FSA ownership is centralized into one entity or dispersed across many entities. Similar

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to the types of ownership structures that emerge in markets, I identify four different types

of FSA ownership structures that MNCs use: 1) sole ownership, 2) shared ownership, 3)

separate ownership, and 4) mixed ownership. I examine descriptive statistics associated

with each structure and with tax haven ownership.

Chapter 4 builds on property rights theory to understand how MNCs allocate the

economic ownership of FSAs to different units within the firm. This chapter investigates

the FSA characteristics that influence the choice of ownership structure. Property rights

theory suggests that in an exchange relationship, the party whose activity makes the

largest contribution to the creation and maintenance of the asset should own the asset.

However, MNCs must balance these considerations against other potential advantages

such as reduced administrative and monitoring costs, reduced bargaining problems, tax

minimization, and greater internal knowledge sharing. This chapter argues that MNCs

with knowledge-intensive, tacit knowledge assets are more likely to have shared FSA

ownership structures, whereas MNCs with independent FSAs and FSAs that require

local, downstream inputs are more likely to have separate FSA ownership structures. The

empirical results strongly support property rights theory predictions.

Chapter 5 investigates whether and to what extent FSA ownership affects

innovation. Although FSAs have long held a central role in the theory of the MNC, the

effects of internal ownership on innovation remains unexamined. Innovation is

inherently difficult to monitor and control. Property rights theory suggests that

ownership provides two incentives for investing in the creation of the asset: 1) the ability

to appropriate income from the innovations created, and 2) the ability to control both the

asset and its future direction of development. I find that subsidiary FSA ownership is

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positively associated with innovation, and that transferring ownership away from the

subsidiaries that create the FSAs has a negative effect on innovation.

This research makes several contributions. First, I contribute to the theory of the

MNC by shedding new light on how FSAs are internally organized, developed, and

managed within MNCs. Due to the lack of publicly available data, previous research has

not been able to open up the black box of internal MNC transactions. FSA ownership is

important because through the contractual relationships risk is shifted from the FSA users

to the FSA owners, and the FSA owners are centrally positioned in the firm’s internal

network of financial, knowledge, and product flows. Therefore the FSA owners can have

a significant effect on MNC investment and innovation. Second, I extend property rights

theory to inside the firm and identify the types of FSAs that are more likely to be solely

owned by one entity, co-owned by two or more entities, or separately owned by different

entities within the MNC. This research suggests that internalization is not sufficient for

resolving the problems associated with contracting for knowledge and provides insight

into the ability of property rights theory to explain internal firm behavior. Third, I

investigate how the internal governance of FSAs affects the creation of new FSAs by

analyzing how subsidiary FSA ownership influences subsidiary technological innovation.

Finally, I explore the role of tax havens and FSA ownership.

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2. Theoretical Background

FSAs and the MNC 2.1

The management of firm-specific advantages (FSA) is at the core of theorizing

about the existence of MNCs and firms in general (Buckley and Casson, 1976; Dunning,

1977; Rugman, 1980; Barney, 1991; Grant, 1996; Kogut and Zander, 1992). The firm is

conceptualized as a bundle of heterogeneous resources and assets (Amit and Shoemaker,

1993; Penrose, 1959), of which firm-specific advantages are considered the most

important (Barney, 1991; Rugman and Verbeke, 2001). FSAs provide firms with

competitive advantages, enable them to generate profits, and expand abroad. FSAs are

the reason why multinational firms exist. The literature on MNCs suggests that firms

internalize transactions when FSAs are not suitable to contract or license in the market

(Buckley and Casson, 1976; Rugman, 1980). Market failures and uncertainties create

bargaining problems and agency costs, which make it more efficient to transact inside the

boundaries of the firm than in markets. However, these same FSAs deemed unsuitable

for external contracting and licensing are extensively contracted and licensed between

subsidiaries and/or the parent within the MNC.

Referred to as competencies, knowledge assets, and firm-specific advantages in the

management and international business literature, FSAs are considered by many as the

most important source of above normal returns (e.g. Rugman and Verbeke, 2001;

Drucker, 1995; Spender and Grant, 1996). FSAs include technologies, patents, brands,

know-how, and organizational routines (Birkinshaw, Nobel and Riddensdale, 2002).

Rugman and Verbeke (2001) explain that FSAs are the unique company strengths, which

include a broad range of functional, technological, and organizational proprietary assets

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and know-how. FSAs include technological and/or marketing knowledge, and superior

managerial capabilities to control and coordinate international transactions (Buckley and

Hashai, 2009). FSAs provide the firm with a competitive advantage and are thus a key

source of above normal profits.

This research applies property rights theory (e.g. Grossman and Hart, 1986; Hart

and Moore, 1990) to the internal structure of the MNC. Although property rights theory

is typically applied to external exchange relationships, extending it to the internal

contracting structure and relationships between entities within the MNC can enhance our

understanding of the firm. In contrast to transaction cost economics which focuses on the

characteristics of transactions, property rights theory focuses on the characteristics of

assets and asserts that ownership of an asset can be broken into sets of rights to the asset.

Taking the view that the firm is a bundle of heterogeneous assets, property rights theory

allows us to ask how the rights to the MNC’s key value-driving assets are allocated

across its network of subsidiaries.

Property Rights Theory and the Firm 2.2

The Theory of the Firm (Coase, 1937) spawned a large literature on the

internalization of transactions within the boundaries of the firm. One stream of research

that developed from Coase (1937) is property rights theory (Grossman and Hart, 1986;

Hart and Moore, 1990). Property rights theory focuses on the question of who owns the

property rights of the assets in an exchange relationship (Foss and Foss, 2001). Property

rights are defined as “any sanctioned behavioral relations among decision makers in the

use of potentially valuable resources; such sanctioned behaviors allow people the right to

use resources within the class of non-prohibited uses” (Asher et al, 2005: pp. 7).

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Property rights may include the right to use, exclude others from use, appropriate income,

and transfer or invest in the resource (Foss and Foss, 2001). The multidimensionality of

rights to an asset means that different entities can hold different rights to the asset. In the

case of the MNC, this means that different subsidiaries can hold different rights to the

MNC’s key assets. For example, a subsidiary may have the right to manufacture a

product, but not the right to sell the product in particular markets. Viewing a firm as a

bundle of assets, the rights of subsidiaries to the MNC’s FSAs can affect their role,

appropriation of income, incentives, and formal linkages to other subsidiaries within the

firm (operational structure).

A fundamental assumption in property rights theory is that contracts are

incomplete - it is impossible to specify all terms and contingencies in advance.

Unforeseen contingencies and the costs of writing and enforcing contracts make contracts

incomplete (Tirole, 1999). Internal transactions of goods, services, and knowledge assets

between MNC entities face similar challenges as external market transactions. FSAs, by

nature, are incomplete. Foss and Foss (1998) claim that intangible assets are a source of

incomplete contracts that lead to imperfectly specified rights. Moreover, MNCs are faced

with diverse risks and uncertainties from their global operations. Shifts in global

demand, prices, and costs create large risks within the MNC causing incomplete internal

contracts.

Incompleteness gives rise to two types of entities in an exchange relationship: 1)

specific rights owner, and 2) residual rights owner. The specific rights owner performs

activities as specified in a contract in return for a guaranteed income. Because the

specific rights owner is guaranteed a return, its exposure to risk is mitigated. The

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residual rights owner bears the risk associated with the exchange relationship. It receives

the profit or loss based on the difference between the total income and the payments

promised to the specific rights owner (Jensen, 1986). The classical example of a specific-

residual relationship is the employment contract where individuals prefer to be hired as

employees directed to perform tasks in return for a guaranteed wage (Coase, 1937). The

entrepreneur (residual rights owner) takes the residual, fluctuating income (or loss) above

the amount promised to the employees (Coase, 1937).

Extending this concept to MNC and the contractual relationships between entities,

the FSA owners within the MNC are the residual rights owners. The affiliates that

license the FSAs, or are contracted to perform various functional activities (FSA users),

are the specific rights owners. The FSA owners contract the FSA users within the firm to

perform various functions in return for a guaranteed return. The FSA owners bear the

risk of the fluctuating income. By allocating various rights between the related affiliates,

MNCs are able to shift the effects of risk and uncertainties to various units within the

firm.

The concept of residual ownership is equivalent to economic ownership (Barzel,

1997). Economic ownership, which is conceptually distinct from equity and legal

ownership (Barzel, 1997), is based on ultimately bearing the costs and risks associated

with the activities. Fama and Jensen (1983) note that most organizational forms have

contract structures that limit the risks undertaken by most agents through specifying fixed

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or incentive payoffs.1 The following provides an example of residual-specific rights

ownership within the MNC.

Figure 1: Example of FSA Ownership and Contracting and Licensing

Arrangements

The FSA owners are the entities that bear the risk and not necessarily the entities

that physically create the MNC FSAs. For example, a pharmaceutical MNC has an R&D

affiliate located in India. The FSA owner, which is a U.S. affiliate, contracts the Indian

affiliate to perform R&D activities. The FSA owner agrees to reimburse the Indian R&D

affiliate for all of its R&D costs, plus a 15% mark-up on its R&D costs for the R&D

1 While economic ownership may overlap with equity and legal ownership, it is conceptually distinct.

Alchian and Demsetz (1973) explain that property rights deal with the right to use the resource, and not

legal ownership per se. Barzel (1997) distinguishes between economic and legal rights, viewing economic

rights as the more relevant concept of property rights. Barzel (1997) argues that economic rights, or the

right to residual income, are the ends that agents seek whereas legal rights are the means to achieve the

ends. While legal rights are recognized by governments and enhance economic rights, they are neither

necessary nor sufficient for economic rights (Barzel, 1997). Under property rights theory, the concept of

residual rights ownership can be detached from equity ownership (Fama and Jensen, 1983). Zingales

(2000) argues that viewing the shareholders of the firm as residual claimants is a narrow view of the

residual claimant. Fama (1980) goes so far as to suggest that ownership of the firm is “an irrelevant

concept” (p 290). The view held in this paper is that, within the MNC, the economic owners of the MNC

FSAs are the residual claimants within the MNC.

FSA Owner Drug Discovery,

Drug Formulas, and

Trademarks

UK licenses FSAs from U.S.

U.S. Subsidiary

U.S. contracts India to perform R&D

UK Subsidiary

Sales and

Distribution

Shifts

Development

Risk India Subsidiary

Research and

Development

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services. The Indian affiliate is a specific rights owner as it is guaranteed to earn a return

(markup on its R&D expenses), regardless of the outcome of its activities. If the R&D

affiliate is not able to successfully develop a new drug, or if it takes it an extra five years

to do so, the U.S. affiliate is responsible for the losses associated with the Indian

affiliate’s R&D activities and the Indian R&D affiliate continues to earn the stable 15%

return on its R&D activities. If, however, the Indian affiliate successfully develops a new

product, the U.S. affiliate, as the FSA owner, receives any profit that is above the 15%

return given to the Indian R&D affiliate. In other words, it receives the above normal

returns (residual income) for any newly created FSAs.

Thus, the entities within the MNC can be categorized into two groups: 1) FSA

owners, and 2) FSA users. The FSA owners can be the parent and/or affiliates within the

MNC. Some FSA owners may perform operational activities, such as R&D,

manufacturing, or distribution, whereas others may be tax haven entities with no

operational activities. MNCs may have one, several, or many FSA owners. FSA users

are the affiliates and/or parent that do not own the economic rights to the MNC FSAs.

These entities are either contracted by the FSA owner(s) to perform specific activities

such as R&D, manufacturing or distribution, or they license the rights to use the MNC

FSAs from the FSA owner.

The concept of residual income is equivalent to the strategy concept of above

average returns. Residual income is the income in excess of normal (market) returns for

the activity performed. Above normal returns are attributed to firm-specific advantages

(e.g. Rugman and Verbeke, 2001). Thus, FSAs are the important value-drivers of

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multinational firms. Firm-specific advantages are dynamic; firms must continuously

work to develop and maintain their competitive advantage (Buckley and Casson, 1976).

The development of FSAs is risky. The separation of specific rights from residual

rights facilitates the risk sharing between the agents in an exchange and the allocation of

economic rents. It is important to note that there are downsides to FSA ownership. Fama

(1980) states that the asset owner, as residual claimant, receives the “uncertain and

possibly negative difference between total revenues and costs at the end of each

production period” (pp. 290). The residual rights owner (Alchian and Demsetz, 1972) is

also called residual claimant (Klein, 1983), residual risk bearer (Fama, 1980; Fama and

Jensen, 1983), and economic rights owner (Barzel, 1997) in the literature. In terms of the

MNC, the affiliates that take on the risks of developing FSAs are the residual rights

owners. These entities bear the consequence of failure to achieve above normal returns.

The role of the residual rights owners is to insulate the other entities within the

MNC from risk. Through guaranteeing FSA users a specified return on their activities,

risk is shifted across globally dispersed locations. This has several important

implications. First, it determines the risk exposure of the MNC entities. Different

contractual terms may shift different levels of risks to or from the FSA users and FSA

owners. Second, FSA ownership determines the entities’ investment incentives. While

FSA owners are motivated to make investments that increase the value of the FSAs, non-

owners have reduced incentives for investment. As a result, the structure affects

economic behavior and outcomes (Kim and Mahoney, 2005). Third, it determines which

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entities control the financial resources of the firm.2 In return for bearing the risk, the FSA

owners are entitled to the residual income from the FSAs. This empowers the FSA

owners in resource allocation. Property rights theorists note that asset ownership

provides the owner with power and control over the operations (Hart and Moore 1990;

Rajan and Zingales, 2000). The residual rights owners have the ability to coordinate and

allocate tasks to the non-owning users and the power to punish the users by withholding

resource allocations, re-directing tasks, and exiting businesses (Rajan and Zingales,

2000). Grossman and Hart (1986) argue that residual rights ownership is important

because the owner can influence the solutions to problems and the strategic direction of

future intangible assets. As a result, I expect that FSA ownership will have a significant

effect on MNC incentives, resource allocation, and strategic decisions.

The relationship between the FSA owners and FSA users within the firm is aligned

with Teece’s (1986) observation of the need to own complimentary activities in order to

capture the returns from innovation. The purpose of property rights is to maximize value

and transfer resources to their best uses. Different ownership structures emerge in

response to “economic problem of allocating scarce resources” (Kim and Mahoney,

2005). Allocation of property rights is viewed as an efficient means of dividing

economic rents and avoiding inefficient expropriation and underinvestment (Asher et al,

2005; Rajan and Zingales, 2000). Property rights facilitate implementing value-creating

activities so that resources are channeled to high yield uses (Kim and Mahoney, 2002).

The contractual relationships with FSA users prevent bargaining problems within the

MNC over which entities control the FSAs and the allocation of income from the FSAs

2 Although the parent can repatriate income, tax consequences and the bargaining power of the FSA owner

may discourage repatriation.

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within the firm. It also prevents future conflicts as to whether an affiliate created a

particular MNC FSA. By contracting the FSA users within the firm to perform various

functional activities, the FSA owner is entitled to the ownership of any FSAs that the

FSA user creates while under the contractual relationship. Therefore the FSA owner will

continue to own any future developed FSAs.

From the ownership of FSAs emerges the internal MNC network of exchange

relationships. As noted by Grant (1996) the drive towards specialization within the firm

creates a need for coordination mechanisms. In markets, the coordinator is the

entrepreneur. Within the MNC, it is the FSA owners which contract and license the FSA

user entities. Through contracting and licensing affiliates, the FSA owners coordinate

MNC activities.

The internal ownership of FSAs is important for several reasons. First, ownership

of FSAs is central to the theory of the multinational firm. Although an extensive amount

of research has been conducted on FSA ownership at the MNC-level, FSA ownership

within the MNC is unexplored. Through exploring questions such as how internal

contracting and licensing is similar to or distinct from external market contracting and

licensing, we can advance the theory of the multinational firm. Second, research on

internal FSA ownership can deepen our understanding of the internal organization and

network structure of the firm (e.g. Bartlett and Ghoshal, 1989; Gupta and Govindarajan,

1991). FSA owners, as the entities that contract and license FSAs to other entities within

the MNC, are centrally positioned in the MNC internal network of financial, knowledge,

and product flows. Third, internal licensing and contracting separates ownership from

control of real operations. The economics literature suggests that various adverse

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incentive effects arise from the separation of ownership and control. It is important to

understand its impact on organizational outcomes. Fourth, FSA ownership affects the

power distribution and decision making authority within the MNC. The FSA owners are

legally entitled to the residual profits of the MNC (e.g. Internal Revenue Code Section

1.482; OECD Guidelines).3 Once established, transferring FSA ownership can be

prohibitively costly. Their contracting and licensing activities combined with entitlement

to profits means that FSA owners may play a significant role in determining MNC

resource allocation and strategy. Research on affiliate-level FSA ownership has the

potential to make many contributions to the international business literature.

3 OECD Guidelines as well as local country regulations require that entities pay for the FSAs that they

acquire from other entities within the MNC.

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3. Data

In order to test the predictions, I compiled a novel dataset of MNC FSA

ownership. The primary source of data was MNC transfer pricing reports from a

consulting firm. Transfer pricing is the intercompany pricing of goods, services, and

intangible assets between MNC entities. According to U.S. Treasury Regulations Section

1.482, Organization for Cooperation and Development (OECD) Transfer Pricing

Guidelines, and various other local country requirements, MNCs must document their

intra-company transactions in transfer pricing reports each year. Although

documentation requirements are country-specific, many countries follow the OECD

Guidelines for transfer pricing and most countries require that all material related-party

activities are documented contemporaneous with the firm’s tax filing.

MNCs hire consulting firms to document their intra-company transactions. The

consulting firms collect for the reports the MNC financials, organizational charts,

headcount by function, and intra-company agreements. The intra-company agreements

describe the transactional relationships, risks, economic owners of the intangible

property, payments, and contractual terms for the intra-firm transactions. The consultants

conduct interviews with senior managers and C-level executives to confirm whether the

activities were in accordance with the intra-company agreements. Any discrepancies are

documented in the reports. Since the reports document multi-year averages, MNCs

usually provide three years of consolidating income statement and balance sheet data.

The data for this research was put together under strict confidentiality. For this

reason, no company names or company-specific information can be identified. All

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summary statistics show means, standard deviations, or other statistical measures, and

any descriptions are redacted or have the names changed to maintain anonymity.

Two datasets were compiled from the transfer pricing data: a MNC-level dataset

and a subsidiary-level dataset. The dataset is an unbalanced, longitudinal dataset since

the transfer pricing reports typically cover multiple years of data in order to take into

account business cycle and many of the MNCs repeatedly use the consulting firm for

services, making longer periods of time available. The sample is composed of 102

MNCs over the 1997-2012 time period on which the consulting firm had the most

comprehensive data. The sample contains a diverse group of MNCs, operating in a broad

range of industries and headquartered in a number of countries. The MNCs in the sample

had a combined total of 7,156 subsidiaries.

In addition to data on internal FSA ownership and contracting and licensing

arrangements, I collected patent data from the United States Patent and Trademark Office

(USPTO). I searched for all granted patents assigned to each MNC or to any subsidiary

within the MNC’s group. Following standard practice, the patents were matched to years

based on the filing date. I used the inventor city, state, and country information to match

each inventor location to a MNC subsidiary. Matching patents to inventor location

provides a much closer measure of subsidiary innovation than matching by assignees,

which can be biased by the intellectual property strategies of the MNCs. The MNCs in

the sample patented 50,934 patents over the sample period. 29,028 of the patents had

only one inventor and 10,711 patents had multiple inventors from the same subsidiary

location and therefore were coded to only one subsidiary. The remaining 11,195 patents

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had inventors from more than one subsidiary location and were therefore coded to

multiple subsidiaries.

Coding of Data 3.1

Intangible Asset Definition. Transfer pricing reports discuss the MNC’s

“intangible assets” or “intellectual property.” The OECD defines an intangible asset as:

“not a physical asset or a financial asset, which is capable of being owned or

controlled for use in commercial activities, and whose use or transfer would be

compensated had it occurred in a transaction between independent parties in

comparable circumstances” (OECD 2013: 14).

Moreover, unique and valuable intangibles are:

“those intangibles (i) that are not comparable to intangibles used by or available to

parties to potentially comparable transactions, and (ii) whose use in business

operations (e.g. manufacturing, provision of services, marketing, sales or

administration) is expected to yield greater future economic benefits than would

be expected in the absence of the intangible” (OECD 2013).

OECD guidelines give several examples of the types of assets classified as

intangibles, including patents, know-how and trade secrets, trademarks and trade names

(OECD 2013). The definition of valuable intangible assets is closely aligned with the

strategy concept of core competencies and international business literature concept of

FSAs.

MNCs have different types of FSAs, ranging from product innovations to know-

how and formulas. The following table shows the different categories of intangible assets

listed in the transfer pricing reports for the MNCs in the sample.

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Table 1: Coding of FSAs

FSA Category Example Description of FSA

Product [MNC's] intangible assets relate to its products. [MNC] has X product

families. [MNC] engages in developing and marketing products for

[industry]. [MNC]’s products include cutting edge [technology], are

highly integrated and offer high-quality performance. [MNC] expects that

its continued R&D efforts for [product line], which represents next-

generation technology based on the persisting legacy technology, will lead

to large sales growth.

Drug Discovery The profitability of [MNC] is determined by the successfulness of its drug

discovery, development, and commercialization capabilities. Drug

discovery activities include molecular discovery research.

Manufacturing Process [MNC] has proprietary manufacturing processes that provide it with

competitive advantages. Its manufacturing processes enable it to produce

high-quality products at prices lower than its competitors.

Procurement Know-How [MNC] Procurement Intangibles: [FSA owner] owns the rights to a

number of processes, procedures and proprietary tools used to optimize

the procurement of materials used in [MNC]’s operations. In order to

ensure high quality and consistency of suppliers, [FSA owner] has set

standards for all third parties that supply materials to affiliates located

worldwide, and developed a proprietary system for affiliates to evaluate,

select, monitor, and change suppliers.

Trademark and Marketing The brands owned by [MNC] are a significant source of value. [FSA

owner X] owns the worldwide rights to the valuable [Brand X] and

related trademarks.... [FSA owner Y] owns the rights to [Brand Y].

[Brand Y] is a highly regarded domestic and international brand in the X

industry. Third parties pay a considerable premium for the [Brand]

products due to the brand name.

Blends and Recipes [MNC]-owned intangible property is related to the blend formula and

recipes for creating the products sold by [MNC]. Primary processing

consists of blending chemicals in a batch run. Trade secrets and know-

how related to the blend formula and mixing procedures are also important

to the production process. The blends and formulas of [MNC]'s products

are proprietary to [FSA owner].

Retail Store Design Layout [MNC] Store Design Intangibles: [MNC] has specialized retail store

designs and layouts which [MNC] considers crucial for its brand image

and the ability of [MNC] to attract and retain customers.

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Table 1: Coding of FSAs Continued.

FSA Category Example Description of FSA

Expertise and Know-How The services and know-how provided by the local subsidiaries drive

[MNC]'s profits. [MNC's] business requires highly skilled technical

experts. The local subsidiaries provide unique services, due to their

functional or geographic (depending on the entity) expertise. Because of

their unique skill and expertise, they are largely able to dictate the prices to

customers.

Customer Relationships Local customer relationships are important. [MNC's] trademark has no

value in a new market and therefore each local sales subsidiary must

create all customer relationships through its own intensive selling and

marketing activities. The sales subsidiaries make substantial investments in

relationship building and in the subsequent customer maintenance process.

The required time to build customer relationships varies by geographic

region, meaning that some sales subsidiaries incur losses for some time

while going through initial market penetration activities. The sales

subsidiaries have established loyal customer bases in their markets. These

relationships are valuable, locally developed intangible assets that are

owned by each local sales subsidiary.

Services [MNC]'s core strength is its service capabilities. [MNC] has the biggest

service network of any of the [industry] manufacturers. Customers in the

[X and Y industry sectors] seek [MNC]'s products due to its vast service

network, which provides [MNC] the ability to provide services anywhere

in the world.

Counter Example: MNC has

No Product Innovation FSA

[MNC] technology is relatively old and has not been updated or further

developed since [year]. Therefore, [MNC] currently incurs few to no

costs associated with developing, maintaining, or defending this

technology. Moreover, there is no market for the technology. The

products are considered standardized products.

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Figure 2: Types of FSAs

Figure 2 provides a breakdown of the different types of FSAs owned by MNCs in

the sample. As shown in the pie chart, 42% of observations in the sample had product

innovation FSAs, 29% had trademark and marketing FSAs, 12% had manufacturing

processes, and the remaining had various other FSAs including distribution and retail,

drug discovery, and expertise and services, etc. MNCs sometimes indicate that they own

multiple FSAs. The most common overlap of FSA types was product innovation and

trademark intangibles.

Intangible Asset Owner Definition. I used the detailed information provided in the

transfer pricing reports to identify and code the intangible asset owners within the MNC.

The transfer pricing reports identify the intangible asset owners associated with each

intercompany transaction in order to determine which entity should receive any profits or

losses from the intra-company transactions. Intangible asset ownership under transfer

Drug Discovery4%

Product Innovation

42%

Manufacturing Processes

12%

Trademark & Marketing

29%

Customer Relationships

3%

Blends & Recipes

2%

Procurement Know how

1%Expertise &

Services5%

Distribution & Retail

2%

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pricing guidelines is based on economic ownership. The intangible asset owners bear the

risk of intangible asset development or purchase previously developed intangible assets

from affiliates.

Intangible asset owners for each MNC were explicitly identified in the transfer

pricing reports. Ownership is also supported with the written legal contracts between

MNC entities and real flows within the firm. All transfer pricing reports for each MNC

were carefully reviewed and each intangible asset owner for each MNC was recorded, its

country of incorporation, and the functions performed by the intangible asset owner.

Tax haven Ownership. I code tax haven ownership as a binary indicator variable,

set equal to 0 if the country of incorporation of at least one of the MNC’s intangible asset

owners is a tax haven country. Tax haven countries were identified based on the OECD’s

list of tax havens (OECD, 2000). Some MNCs have FSA owners in tax haven countries

that perform substantial operational activities and significantly contribute to the

development of MNC FSAs. For this reason, I code two separate tax haven variables.

Operational Tax Haven is a binary indicator set equal to one if the FSA owner is located

in a tax haven country and performs R&D, distribution, manufacturing, or service

activities. Pure Tax Haven is a binary indicator set equal to one if the FSA owner is

located in a tax haven country and does not perform R&D, manufacturing, distribution,

sales and marketing activities, or financial trading (for banking firms).

FSA Ownership Structures 3.2

FSA Ownership Structures. MNC intangible asset ownership structures differ

along three dimensions: 1) the extent to which the ownership of their intangible assets is

centralized into one entity or dispersed across many entities, 2) whether ownership is

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shared between entities or owned separately by entities, 3) whether the ownership is

located in tax havens.

From the information contained in the reports, I identified four types of intangible

asset ownership structures and coded each MNC according to its structure: 1) sole

ownership, where one entity owns all of the MNC’s intangible assets, 2) shared

ownership, where two or more entities share ownership of the intangible assets, and 3)

separate ownership where different intangible assets are separately owned by different

entities within the MNC, and 4) mixed ownership where some entities share ownership of

certain intangible assets and other entities own separate and distinct intangible assets.

Overlapping all of these types of structures is tax haven ownership, where one or more of

the intangible asset owners are located in tax haven locations.

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Table 2: Coding of FSA Ownership Structures

Each structure has its advantages and disadvantages. The following provides an

overview of each structure.

3.2.1 Sole Ownership

Sole ownership occurs when one entity within the MNC owns the rights to all of

the MNC’s FSAs, regardless of where R&D, manufacturing, distribution, or marketing

Ownership Structure Definition Examples of Phrases Used in Reports

Sole* • • [Entity] is the owner of all intangible assets owned by [the

MNC].

• [Entity] owns, manages, and maintains [MNC's] portfolio

of intangible assets. These assets include, but are not

limited to, trademarks, process and information

technology, know-how, patents, industrial models, and all

other intellectual capital.

Shared • • [Entity] and [Entity] share ownership of the rights to all of

the techologies and trademarks associated with the

products owned by [MNC].

• Pursuant to the Cost Share Agreement, [Entity] and

[Entity] share all costs, risks, and rights to all of the

Company's intellectual property.

Separate • • [Entity A] owns the rights to [FSA 1]… [Entity B] owns

the rights to [FSA 2],…. and [Entity C] owns the rights to

[FSA 3].

• Each [distribution entities] own the rights to their local

market intangibles.

Mixed • • [Entity A] and [Entity B] share ownership of [X

FSAs]…[Entity C] owns the rights to [Y FSAs].

• [Entity A] is the economic owner and bears all costs and

risks of [MNC's] activities associated with [X FSAs].

Under the terms of a Cost Share Agreement, [Entity A]

and [Entity B] share the rights, risks and costs associated

with [FSAs]. [Entity D] owns the rights to [X FSAs].

All FSAs owned by the

MNC are owned by one

entity.

Two or more entities

within the firm share

ownership of the MNC’s

FSAs.

Two or more entities

within the MNC own the

rights to separate and

distinct MNC FSAs.

Two or more entities

share ownership of at

least one FSA and at

least one other entity

owns a separate and

distinct FSA.

* For MNCs that did not explicitly state that one entity owns all the FSAs, a MNC was also coded as having a

sole ownership structure if only one entity was named as the owner of FSAs in all of the MNC’s transfer pricing

reports.

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activities occur within the firm. Figure 3 shows an example of a sole ownership

structure.

Figure 3: Sole Ownership Structure

In the above example, the parent is the only FSA owner of the MNC. The parent

owns all FSAs and contracts all other entities within the MNC to perform activities such

as R&D, manufacturing, and distribution. The FSA owner acts as a financial

intermediary in the trade relationships within the firm. Even though product flows

directly from the U.S. intermediate goods manufacturer to the U.K. finished goods

manufacturer, and from the U.K. finished goods manufacturer to the German distributor,

the FSA owner handles the financial flows by directly paying each entity for the services

performed and/or charging them for the goods received.

Sole ownership structures generate limited incentives within the firm since all but

one entity do not own FSAs (FSA users). FSA users earn a guaranteed income on their

activities, but do not have rights to residual profits earned from the FSA. Sole ownership

structures centralize operational risks such as development, market penetration,

manufacturing, and warranty risks into one entity. They also allow for centralized

Royalties for

FSAs

Risk & Residual

Income (Loss)

Specified Return

Product Flow

France U.S. South Korea

FSA User FSA User FSA User

R&D Manufacturing Manufacturing

Intermediate Goods Distribution

Product Flow Product Flow

Finished Goods

Parent

FSA Owner

Germany

Distribution

UK

Manufacturing

FSA User FSA User

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coordination and control. Information flows from the FSA users to the one FSA owner

and from the one FSA owner to the FSA users. The information flows and connections

enable the FSA owner to direct the implementation of a new technology or innovation

across the group and to disseminate best practices learned from FSA users throughout the

firm. However, since all FSA users report to the one FSA owner, bounded rationality can

limit the FSA owner’s ability to identify the best investment opportunities. Therefore,

sole ownership should be particularly advantageous for small firms.

Sole ownership structures are administratively simple, easy to manage, and create

efficiency gains by having only one FSA-owning entity – usually the parent – contract

with the FSA users throughout the firm. Having a single FSA owner facilitates

monitoring the performance of FSA users and reduces the administrative complexity

associated with extensive intra-firm flows of FSA cross-licenses and royalties. Sole

ownership structures limit disputes and bargaining problems between MNC entities

regarding the allocation of returns since there is only one FSA owner within the firm.

The ease of management, low levels of bargaining problems, and ability to control and

leverage best practices make this structure also beneficial for very large firms that want to

reduce administrative complexity and have greater integration and control of their

operations.

3.2.2 Shared Ownership

Shared ownership of FSAs occurs when two or more entities co-own all of the

MNC’s FSAs. Under a shared ownership structure, the costs, risks, and benefits of the

FSA are shared between owners based on the relative contribution to the FSA,

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geographical region, or field of use. Figure 4 provides an example of a shared ownership

structure based on geographical region.

Figure 4: Shared Ownership Structure

In the above example, the French entity owns the European rights to the FSAs and

the parent firm owns the U.S. and Asian rights to the FSAs. The FSA owners are

responsible for licensing the FSAs and contracting the FSA users for products or services

distributed within their region. Therefore, the French FSA owner contracts the U.S. and

U.K. entities to manufacture products and the German entity to distribute those products

in Europe. The U.S. contracts the South Korean entity to manufacture and distribute

product in Asia. The FSA owners share the costs of developing the FSAs and share the

risks and returns based on geographical regions. Thus, if the U.S. and Asian revenues

combined represent 65 percent of the total revenues of the MNC, the U.S. FSA owner

pays 65 percent of the development costs.

In shared ownership structures, the co-owners share incentives, control, and risks,

which can increase the MNC’s ability to expand geographically and engage in more risky

investment projects in the hopes of furthering growth. Shared ownership structures are

Royalties for FSAs

Risk & Residual

Income (Loss)

Specified Return

Product Flow

U.S.

FSA User

Manufacturing

Intermediate Goods

Product Flow Product Flow

Distribution

Responsible

Parent

FSA Owner

Germany

Distribution

South Korea

Manufacturing

for US & Asia

FSA User FSA User

Share FSA Development Costs

and Risks

France

FSA Owner

Responsible

Finished Goods

UK

Manufacturing

for Europe

FSA User

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the used by the most R&D intensive firms. For these firms, joint ownership incentivizes

sharing knowledge and collaborating to increase total FSA value. Shared ownership

structures offer the greatest potential to coordinate within the firm in that different FSA

owners can manage regions, divisions or units, and work with other FSA owners to

decide the best strategic actions to take. Since different affiliates report to specific FSA

owners, information flows are more manageable and the problems of information

overload that can occur with only one FSA owner are mitigated.

An important disadvantage of shared ownership is that FSA co-owners share

power over decisions related to the FSA. Bargaining problems may arise between the co-

owners and differences of opinion can lead to non-optimal decision making. Shared

ownership structures are administratively more complex than sole ownership structures.

The co-owners contract different FSA users, so there is some duplication of efforts as

each FSA owner manages internal relationships.

3.2.3 Separate Ownership

Separate ownership occurs when two or more entities within the MNC own

different FSAs. For example, the Singapore affiliate of a consumer goods company may

own the rights to a technology and the UK affiliate may own the rights to a brand.

Alternatively, FSA ownership may be separated based on technologies, products,

localized relationships, brand names, or a mix of the above. The FSA owners license the

FSAs or contract the FSA users to perform activities. If the FSA owners want to use each

other’s FSAs, they cross license the rights to their FSAs. Figure 5 provides an example

of a separate ownership structure.

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Figure 5: Separate Ownership Structure

In the above example of separate FSA ownership, there are four FSA owners.

Each FSA owner owns a distinct FSA. The parent firm owns the FSAs associated with

product group 1 and the French entity owns the FSAs associated with product group 2.

The U.S. entity owns the FSAs associated with its manufacturing processes. The U.S.

entity sells its intermediate goods directly to the U.K. manufacturing entity. The U.K.

manufacturing entity pays the U.S. intermediate manufacturer directly. Since the U.S.

manufacturing entity is an FSA owner, it is able to keep the profits associated with its

manufacturing activities. The South Korean entity owns the rights to the brand name and

marketing intangibles for the South Korean market. The South Korean entity sells

products from product groups 1 and 2. As a result, it pays both FSA owners royalties for

the products that it sells. Since the South Korean entity owns the rights to the brand

intangibles, it bears the risks associated with market penetration and brand development

in its region and is able to keep any profits from the brand intangibles. This incentivizes

the South Korean entity to create brand value in its region. The parent and French

entities are responsible for developing their own product groups and bear the risks as well

Royalties for FSAs

Risk & Residual

Income (Loss)

Specified Return

Product Flow

Product Flow

Manufacturing

Distribution

Product Groups

1 & 2

Product Flow

U.S.

1 & 2 1 & 2

FSA Owner

Manuf. Intangibles

Manufacturing

Intermediate Goods

Manufacturing

Product Groups Product Groups

FSA Owner

Product Group 1

Distribution

U.K. Germany

FSA User FSA User

France

FSA Owner

Product Group 2

Intangibles Intangibles

Parent

South Korea

FSA Owner

Brand Intangibles

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as returns from their efforts. The U.K. manufacturer and German distributor do not own

the rights to any FSAs. Instead they earn set returns on their manufacturing costs.

By dispersing risk and control rights to FSA units throughout the firm, separate

ownership structures create market-like incentives. In comparison to sole ownership

structures, separate ownership structures can improve MNC investment decisions since

the entities that are best positioned to make decisions about the FSAs own and control

them. Separate ownership tends to create fewer bargaining problems than shared

ownership since each FSA owner has full control over an FSA and does not need another

party’s approval to make a decision.

Despite their advantages, separate ownership structures can increase the difficulty

of leveraging innovations and best practices across the firm. Information flows between

the FSA users and the particular FSA owner(s) with which they contract. If an FSA

owner were to use an innovation from another FSA owner, it would have to pay the other

FSA owner a royalty for the innovation. Therefore, separate FSA owners have the

incentive to develop innovations themselves and not to source knowledge from other

FSA owners. When information is shared, cross licenses need to be negotiated within the

firm. This can create bargaining problems and increase internal contracting costs.

Additionally, separate structures can make it difficult to inventory the kinds of

knowledge that reside with different FSA owners throughout the firm.

Separate ownership structures are more administratively complex than sole and

shared ownership structures since the different FSA owners act as “mini firms” within the

MNC. To the extent that there is operational overlap from having FSA users perform

activities for multiple FSA owners, it can become complex to track the internal

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transactions and the royalties due to each FSA owner. The MNC may experience

reduced efficiency from duplication of efforts and administrative complexity.

3.2.4 Mixed Ownership

Mixed ownership occurs when two or more entities within the MNC share

ownership of at least one FSA and at least one entity within the MNC owns a separate

and distinct FSA. For example, in a consumer product company, one entity may own the

rights to old technology associated with the legacy product lines and two entities may

share the rights to new technology, which is associated with the new product lines.

Figure 6 provides an example of mixed ownership structure.

Figure 6: Mixed Ownership Structure

The mixed structure is basically a combination of both the shared and separate

structures. In the above example, the French entity and parent share ownership of the

MNC’s product intangibles based on geographical region. The U.S. manufacturer also

separately owns the manufacturing process intangibles and South Korea owns the brand

Royalties for FSAs

Risk &

Income (Loss)

Specified Return

Product Flow

U.S.

FSA Owner

Manuf. Intangibles

Manufacturing

Intermediate Goods

Product Flow Product Flow

South Korea

FSA Owner

Brand Intangibles

Manufacturing

Responsible for

Europe

Responsible for US

and Asia

Share FSA Development Costs and

Risks

FSA Owner FSA Owner

Product Intangibles Product Intangibles

France Parent

Finished Goods

Distribution

FSA User FSA User

Manufacturing Distribution

U.K. Germany

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intangibles. Since the US manufacturer owns the manufacturing process, it directly sells

its manufactured goods to the UK manufacturer and keeps any profits from its activities.

The French FSA owner contracts the UK entity to manufacture product and the German

entity to distribute product within the European region. The parent licenses the product

intangibles to South Korea. South Korea, as an FSA owner bears the risks of market

penetration and brand development in its local market. It therefore keeps any residual

profits above the royalty paid to the parent for the product FSAs.

Mixed ownership structures provide the ability customize ownership of the FSAs

owned by the MNC. Mixed ownership structures provide market-like incentives for the

separate FSA owners within the firm and incentives to collaborate on innovation for the

FSA co-owners within the firm. Mixed ownership structures decentralize coordination as

different FSA owners and co-owners are responsible for different FSAs and activities.

Information flows between the FSA users and the particular FSA owner(s) with which

they contract.

Mixed ownership structures are the most operationally complex. Having different

FSA owners and co-owners means that the firm may experience problems with power

struggles and bargaining. Mixed ownership structures can have operational overlap if

multiple FSA owners contract with the same FSA users, which creates administrative

complexity for managing the different FSAs, activities, transactions, and returns across

the MNC. It is therefore not surprising that among the firms in the sample, very few

choose this type of structure to organize internal ownership rights to FSAs.

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3.2.5 Tax Haven FSA Ownership

Tax haven FSA ownership occurs when MNCs locate all or part of their FSAs in

low tax jurisdictions. Examples of tax haven locations include Ireland, Luxembourg,

Hong Kong, Singapore, Bermuda, and Cayman Islands (OECD, 2000). Tax haven

countries typically implement a combination of policies designed to attract MNCs,

including low tax rates, minimal currency and banking controls, confidentiality, low

interest rates on loans, and high interest rates on deposits. There is variation in the extent

to which tax haven countries require that MNCs locate operations (“material substance”)

within their country. Some countries, such as Cayman Islands, Luxemburg, and

Barbados, have virtually no material substance requirements. Other countries, such as

Ireland, require that MNCs establish material substance by locating real operations within

the country.

Tax haven FSA ownership can occur in any of the FSA ownership structures. Not

all MNCs use tax havens to own FSAs. In the sample, 42 percent of MNCs have tax

haven FSA owners and 17 percent of the sample (38% of the tax haven FSA owners)

have pure tax haven FSA owners. When a tax haven FSA owner has operational

activities such as R&D, manufacturing, or distribution, the employees within the tax

haven entity may make strategic and operational decisions regarding the FSAs. When tax

haven FSA owners have no operational activities, the parent typically makes the strategic

decisions regarding the development and use of the FSAs. In the latter case, the primary

advantages of tax haven ownership are financial (reduced taxes or tax deferral) and/or

growth related.

The following figure contains a breakdown of the types of FSA ownership

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structures used by MNCs, by industry.

Figure 7: FSA Ownership Structure by Industry

As shown in the figure above, the structures used by MNCs vary by industry.

MNCs in services industries and raw materials industries are more likely to use separate

structures than any other structures.

The MNCs that use the different types of structures vary greatly in characteristics.

The following table contains descriptive statistics on MNC characteristics, FSA

dimensions, and FSAs by FSA ownership structure. Superscripts denote significant

differences between structures. Each structure is numbered 1-4 (Sole, Shared, Separate,

and Mixed). Thus, the average R&D intensity for MNCs using a sole structure is 0.16.

The superscripts 2, 3, 4 indicate that the mean value of R&D intensity for sole ownership

is significantly different from the values for the three other types of structures. The R&D

intensity for MNCs using a Shared structure is 0.19 and the superscripts 3 and 4 indicate

this value is significantly different from the R&D intensity values of 0.08 and 0.10 for

Separate and Mixed ownership structures, respectively.

Agriculture

Mining & Construction

Food, Textile, Chem Mnf

Plastics, Metal, & Equip Mnf

Transportation & Comm Services

Wholesale & Retail Trade

Finance, Insurance & Real Estate

Business, Auto & Personal Services

Legal, Edu & Engineering Services

Sole

Shared

Separate

Mixed

0% 20% 40% 60% 80%

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Table 3: Mean MNC Characteristics and FSAs by FSA Ownership Structure

All Mixed

MNC Characteristics (1) (2) (3) (4)

Revenue 13.92 12.622,3,4

13.413,4

14.704

15.83

Assets 14.43 13.082,3,4

13.813,4

15.314

16.31

Number of Subsidiaries 3.63 2.912,3,4

3.343,4

4.024

4.94

R&D Intensity 0.13 0.162,3,4

0.193,4

0.08 0.10

Profitability -0.05 -0.133,4

-0.234

0.06 0.12

Effective Tax Rate 0.26 0.25 0.24 0.28 0.19

Tax Haven FSA Owner 0.51 0.072,3,4

0.843,4

0.584

1.00

Pure Tax Haven FSA Owner 0.19 0.002,3,4

0.543

0.114

0.53

Age 41.66 32.462,3,4

24.923,4

57.564

19.34

Diversification 0.32 0.213,4

0.203,4

0.364

0.90

Number of M&As 1.14 0.473,4

0.633,4

1.68 2.06

US Country of Incorporation 0.75 0.853,4

0.813,4

0.68 0.59

EU Country of Incorporation 0.17 0.032,3,4

0.103,4

0.25 0.41

Other Countries of Incorporation 0.05 0.122,3,4

0.003,4

0.044

0.00

Contractibility

Tacit Scale 1.15 1.742,3

3.123,4

-0.144

1.43

Tacit 31.59 33.142,3,4

46.963,4

24.75 23.75

Codifiable 19.43 14.213,4

14.133,4

26.504

8.72

Independent Scale -0.68 -0.842,3,4

-1.533,4

-0.234

-0.48

Independent 6.02 4.733

6.744

6.804

3.78

Complementary 13.41 13.712,3,4

22.973,4

9.53 8.78

FSAs

Drug Discovery 0.08 0.023,4

0.033,4

0.104

0.28

Product Innovation 0.68 0.712,3,4

0.933

0.524

0.91

Manufacturing Processes 0.19 0.232

0.003,4

0.23 0.38

Procurement Know-how 0.02 0.022,4

0.003,4

0.044

0.00

Distribution 0.04 0.073,4

0.073,4

0.01 0.00

Trademark and Marketing 0.51 0.552,4

0.303,4

0.544

0.78

Blends and Recipes 0.04 0.003,4

0.003,4

0.084

0.00

Expertise and Services 0.09 0.032,3,4

0.003,4

0.174

0.00

Customer Relationships 0.05 0.032,3,4

0.003,4

0.094

0.00

Intermediate Product 0.45 0.572,3,4

0.773,4

0.24 0.38

Consumer Product 0.22 0.093,4

0.163,4

0.284

0.66

Software Programming 0.32 0.392,3

0.593,4

0.164

0.31

Sole Shared Separate

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MNC Entity-Level Data 3.3

The MNC entities (parent and subsidiaries) in the sample come from a broad range

of countries. The following table shows the number of observations for each country and

the mean values of FSA ownership, entity size, R&D intensity, and role. The table shows

that FSA ownership is spread across a diverse set of countries.

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Table 4: Subsidiary Descriptive Statistics by Country

Country Obs.

Tax

Haven

Country

FSA

Owner Parent Role

R&D

Intensity

Ln

Revenue

Ln

Assets

Argentina 148 0.09 0.00 1.22 0.00 5.27 5.10

Armenia 10 0.00 0.00 1.40 0.79 3.47 0.00

Australia 391 0.16 0.01 1.32 0.01 5.59 5.09

Austria 298 0.08 0.00 1.21 0.00 4.82 4.20

Bangladesh 4 0.00 0.00 1.00 0.00 5.69 5.27

Barbados 29 Yes 0.55 0.00 0.07 0.15 6.79 4.39

Belgium 535 0.03 0.00 1.26 0.01 5.37 5.48

Bermuda 52 Yes 0.37 0.00 0.17 0.00 7.44 3.06

Bolivia 1 0.00 0.00 1.00 0.00 0.34 0.00

Bosnia and Herzegovina 7 0.00 0.00 0.86 0.00 0.00 0.00

Brazil 231 0.04 0.00 1.22 0.01 4.96 4.44

Bulgaria 18 0.00 0.00 1.00 0.00 3.99 3.27

Canada 739 0.19 0.00 1.31 0.06 4.65 3.74

Cayman Islands 93 Yes 0.26 0.00 0.29 0.03 5.62 3.46

Channel Islands 12 Yes 0.00 0.00 0.00 0.00 -0.17 3.43

Chile 57 0.07 0.00 1.16 0.07 0.00 0.00

China 567 0.05 0.00 1.47 0.06 4.74 3.55

Colombia 87 0.07 0.00 1.23 0.00 5.28 4.93

Costa Rica 14 0.00 0.00 1.57 0.00 2.15 2.62

Croatia 62 0.00 0.00 0.98 0.03 3.75 4.13

Czech Republic 240 0.03 0.00 1.04 0.02 4.31 4.10

Denmark 239 0.13 0.03 1.27 0.03 4.31 4.28

Dominican Republic 7 Yes 0.00 0.00 1.00 0.00 1.22 0.00

Ecuador 12 0.00 0.00 1.00 0.00 0.18 2.50

Egypt 22 0.00 0.00 1.00 0.00 6.15 7.26

El Salvador 4 0.00 0.00 1.00 0.00 -1.25 0.00

Estonia 27 0.00 0.00 1.19 0.03 4.26 3.49

Ethiopia 2 0.00 0.00 1.00 0.00 5.73 0.00

Fiji 2 0.00 0.00 1.00 0.00 2.94 0.00

Finland 218 0.20 0.00 1.30 0.03 5.08 4.51

France 1,424 0.07 0.00 1.22 0.01 5.03 5.09

Germany 2,943 0.03 0.00 1.10 0.02 4.84 3.39

Ghana 7 0.00 0.00 1.57 0.00 5.09 5.64

Gibraltar 1 Yes 0.00 0.00 0.00 0.00 0.00 0.00

Greece 139 0.12 0.00 1.33 0.00 5.18 5.21

Guatemala 9 0.00 0.00 1.33 0.00 0.83 0.00

Honduras 7 0.00 0.00 1.00 0.00 1.06 3.52

Hong Kong 410 Yes 0.01 0.00 1.20 0.06 4.69 3.22

Hungary 194 0.03 0.00 1.30 0.00 3.88 3.81

Iceland 9 0.00 0.00 1.00 0.00 2.94 3.14

India 234 0.02 0.00 1.28 0.16 3.73 3.39

Indonesia 25 0.00 0.00 1.28 0.00 4.88 5.50

Ireland 799 Yes 0.12 0.01 0.83 0.03 4.70 4.91

Israel 85 0.15 0.02 1.54 0.17 3.85 3.19

Italy 651 0.10 0.00 1.29 0.00 5.16 4.73

Jamaica 10 0.00 0.00 1.00 0.00 3.92 6.55

Japan 365 0.05 0.01 1.47 0.04 5.51 3.97

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Table 4: Subsidiaries by Country Continued

Country Obs.

Tax

Haven

Country

FSA

Owner Parent Role

R&D

Intensity

Ln

Revenue

Ln

Assets

Kenya 10 0.00 0.00 1.70 0.00 5.91 7.44

Latvia 36 0.00 0.00 1.00 0.00 4.31 4.92

Lithuania 16 0.00 0.00 1.00 0.00 4.85 4.17

Luxembourg 135 Yes 0.16 0.00 0.90 0.04 5.09 6.48

Malaysia 170 0.00 0.00 1.32 0.03 4.35 3.69

Malta 17 Yes 0.00 0.00 0.65 0.00 3.91 3.93

Mauritius 10 0.00 0.00 0.10 0.00 4.78 1.82

Mexico 363 0.12 0.00 1.15 0.00 4.14 3.02

Morocco 2 0.00 0.00 1.00 0.00 6.35 0.00

Netherlands 1,315 0.02 0.00 1.00 0.04 4.84 5.17

Netherlands Antilles 3 Yes 0.00 0.00 0.00 0.00 0.00 0.00

New Zealand 95 0.09 0.00 1.11 0.00 4.09 4.12

Nicaragua 2 0.00 0.00 1.50 0.05 0.00 0.00

Nigeria 9 0.00 0.00 1.00 0.00 5.54 5.43

Norway 181 0.08 0.00 1.25 0.00 4.71 4.07

Pakistan 27 0.00 0.00 1.26 0.00 5.99 6.19

Panama 11 Yes 0.00 0.00 1.00 0.00 2.39 3.88

Paraguay 1 0.00 0.00 1.00 0.01 0.02 0.00

Peru 40 0.00 0.00 1.23 0.00 3.53 5.37

Philippines 63 0.08 0.00 1.27 0.00 4.57 4.28

Poland 433 0.05 0.00 1.10 0.00 4.39 4.10

Portugal 164 0.09 0.00 1.26 0.01 4.70 4.34

Romania 165 0.13 0.00 1.03 0.01 2.29 2.68

Russian Federation 165 0.07 0.00 1.17 0.03 2.90 3.06

Saudi Arabia 2 0.00 0.00 2.00 0.00 0.00 0.75

Serbia * 27 0.00 0.00 0.96 0.00 1.73 2.40

Singapore 317 Yes 0.05 0.00 1.22 0.01 5.15 4.40

Slovakia 44 0.00 0.00 1.00 0.00 2.43 2.92

Slovenia 28 0.00 0.00 1.21 0.01 5.16 3.66

South Africa 99 0.04 0.00 1.20 0.00 3.75 2.50

South Korea 309 0.00 0.00 1.36 0.05 4.23 3.92

Spain 785 0.08 0.00 1.18 0.00 4.88 4.47

Sri Lanka 10 0.00 0.00 1.40 0.00 5.94 4.16

Sweden 670 0.07 0.01 1.13 0.02 4.48 4.67

Switzerland 451 Yes 0.24 0.04 1.07 0.13 5.22 4.05

Taiwan 222 0.02 0.00 1.38 0.10 3.53 2.87

Thailand 154 0.00 0.00 1.34 0.00 4.26 3.76

Trinidad & Tobago 15 0.00 0.00 1.47 0.01 3.43 3.81

Turkey 48 0.00 0.00 1.10 0.05 2.00 2.24

Uganda 2 0.00 0.00 1.00 0.00 6.13 5.82

Ukraine 61 0.03 0.00 1.11 0.00 3.41 3.60

United Arab Emirates 22 0.00 0.00 1.27 0.01 2.72 1.05

United Kingdom 8,781 0.06 0.00 1.05 0.02 4.97 3.95

United States of America 2,670 0.16 0.09 1.27 0.07 5.24 5.10

of America (Puerto Rico) 76 0.28 0.00 0.97 0.03 4.65 5.19

Uruguay 17 0.00 0.00 1.24 0.00 2.26 4.67

Venezuela 38 0.11 0.00 1.16 0.00 4.39 3.44

Vietnam 8 0.25 0.00 1.00 0.22 1.98 0.95

Virgin Islands (British) 6 Yes 0.00 0.00 0.00 0.00 -0.93 3.93

Zambia 6 0.00 0.00 1.00 0.00 3.66 3.06

Total 29,741 0.8 0.08 0.01 1.14 0.03 4.78 4.19

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In the dataset, there were only 24 changes in FSA ownership (less than one

percent of observations). The following figure shows the number of changes by year.

Figure 8: Number of Changes in FSA Ownership by Year

The majority of changes in FSA ownership coincides with organizational

restructurings and occurs around the 2008 financial crisis. The number of changes

increases from four in 2006 and 2007 to eight in 2008, before dropping to two in 2009.

Approximately 24% of the changes were transferring ownership to operational non-tax

haven subsidiaries, another 24% transferred ownership to operational tax haven

subsidiaries, 36% were transferred to pure tax haven subsidiaries, and 16% were

transferred to the parent.

Table 5 contains the descriptive statistics on subsidiary, country, and MNC

characteristics by FSA users versus FSA owners.

0

1

2

3

4

5

6

7

8

9

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Number of Changes

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Table 5: Mean Value of Subsidiary Characteristics by FSA Ownership Type

The table contains the mean values of the various variables and the superscripts

indicate significant differences between FSA users and FSA owners. For example, the

mean number of patents produced by FSA users is .26 patents. The superscripts 2 and 3

indicate that .26 is significantly different from the patenting activity of the two FSA

owner types (shared FSA owner versus separate FSA owner). There are remarkable

differences between the FSA users and FSA owners. The FSA owners patent more

inventions, take on more roles, are larger and are much less likely to have been acquired

by the MNC. There are also large differences between FSA owners that share ownership

of FSAs versus those that do not (separate FSA owners). Shared FSA owners have a

All FSA User

Shared FSA

Owner

Separate

FSA Owner

Subsidiary (1) (2) (3)

Patents 0.47 0.262,3

5.003

2.93

Knowledge Sharing 0.20 0.142,3

2.533

0.74

Sole-Invented Patents 0.08 0.042,3

0.983

0.59

Pre-Sample Average Patents 0.09 0.072,3

0.823

0.35

R&D Intensity 0.03 0.032,3

0.203

0.05

Role 1.14 1.112,3

1.713

1.49

Subsidiary Size 4.76 4.612,3

7.883

5.91

M&A Dummy 0.26 0.262,3

0.073

0.23

Country

Country Effective Tax 0.22 0.222

0.203

0.22

Revealed Technological Advantage 0.85 0.843

0.793

0.93

Market Concentration 0.57 0.572

0.543

0.57

MNC

MNC Subsidiaries 182.90 189.002,3

68.173

102.19

MNC Ln Revenue 15.77 15.802,3

14.103

15.51

MNC Average Subsidiary Revenue 0.31 0.282,3

1.413

0.58

MNC Diversification 0.48 0.492,3

0.293

0.40

MNC R&D Intensity 0.07 0.072,3

0.183

0.06

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much higher mean patenting, are more likely to engage in knowledge sharing than

separate FSA owners, have greater R&D intensity and subsidiary size. Interestingly,

shared FSA owners come from smaller MNCs than separate FSA owners.

Summary 3.4

There is large variation in MNC internal FSA ownership. Some MNCs have FSA

ownership centralized into one entity in the corporate group. Other MNCs have

ownership dispersed to many MNC entities. The internal organization of FSAs is not just

a question of centralization versus decentralization. MNCs choose whether to have MNC

entities separately own FSAs versus share FSAs. A surprisingly small number of MNCs

use mixed FSA ownership structures. The descriptive statistics show differences between

the MNCs that select different types of FSA ownership structures and differences

between FSA users and FSA owners. The purpose of this dissertation is to examine what

determines the different structures used by MNCs and explore the implications of FSA

ownership on subsidiary innovation

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4. Inside the MNC: Structuring Ownership of Firm-Specific

Advantages

By

Catherine Magelssen

and

Susan Feinberg

ABSTRACT

This study examines how multinational corporations (MNCs) organize internal

ownership of their firm-specific advantages. Firm-specific advantages are the proprietary

assets that provide the firm with a competitive advantage. In contrast to the assumption

that firm-specific advantages are a public good within the firm, MNCs allocate economic

ownership of their firm-specific advantages to affiliates and/or the parent within the firm.

The MNC entities that own the firm-specific advantages internally contract or license

them to other MNC entities. This study identifies four different ways in which MNCs

choose to structure internal ownership of firm-specific advantages. Drawing on property

rights theory, it is argued that these structures are important in creating incentives and

facilitating coordination within the firm. The results suggest that MNCs with

independent and easily codifiable firm-specific advantages, such as trademarks, are more

likely to use ownership structures that provide market-like incentives. In contrast, MNCs

with knowledge-intensive, tacit firm-specific advantages are more likely to use

ownership structures that facilitate knowledge sharing and coordination within the firm.

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Introduction 4.1

At the heart of the theory of the multinational firm is the idea that firms can exploit

a proprietary knowledge or resource more successfully by directly investing in a foreign

market than by licensing the asset to other firms. The inefficiencies associated with

licensing the asset often stem from a common set of problems related to contracting for

knowledge in conventional markets. Because markets for knowledge often fail, certain

transactions are better accomplished when they are “internalized” by firms (Caves, 1971;

Dunning, 1980; Rugman, 1981). Transaction cost economics and property rights theories

of the firm reach similar conclusions.

Economic theories of the firm have generally considered how contracting

difficulties affect whether transactions are conducted within or between firms. There is

widespread agreement in the fields of strategy and economics regarding the benefits of

“internalization” when contracts are difficult to write. However, once these transactions

are brought inside of firms, very little is known about how they are structured. Property

rights theory explicitly suggests that the same kinds of contracting difficulties that occur

at the boundaries of the firm are also likely to occur inside of firms (Grossman and Hart,

1986; Hart and Moore, 1990; Holmstrom and Roberts, 1998). Thus, the difficulties

inherent in contracting for knowledge in markets may not be resolved by internalization.

This paper examines how multinational corporations (MNCs) internally organize

ownership of their most important value-generating assets. These assets correspond to

what strategy and international business researchers variously call knowledge assets,

resources, competencies, and firm-specific advantages (FSAs). Although the theory of

the MNC suggests that firms establish foreign operations when their FSAs are not

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suitable to contract or license in markets (Dunning, 1980), these same FSAs are

extensively contracted and licensed within MNCs. MNCs use internal contracts between

affiliates and/or the parent to assign economic ownership and control rights to FSAs

inside the firm.1 Since many MNCs grow by acquiring firms with existing FSAs or by

internally developing FSAs in foreign affiliates, firms face the organizational problem of

allocating FSA ownership and control rights across a diverse network of affiliates.

The need to create, maintain, and share FSAs within firms generates internal

motivation and coordination problems similar to those that exist at the boundaries of the

firm. To the extent that the FSAs involve tacit, incomplete, or shared knowledge and

specific investments are required, the same kinds of hold-up problems that occur in

market transactions are likely to occur within firms. This is particularly the case in

MNCs, where a firm’s network of foreign affiliates may be spread over many countries

with different customs, cultures, languages, and institutions. MNCs face additional

complications from the high costs of monitoring activities in a geographically dispersed

global network.

At the boundaries of the firm, the critical choice variable when contracts are hard

to write is whether to undertake a transaction within the firm, in markets, or through

some hybrid arrangement. Within firms, the critical choice variable with regard to

structuring internal transactions is whether to have all the FSAs owned by a single entity

and controlled centrally, to have multiple entities separately own the FSAs, or to have

multiple entities share ownership of the FSAs.

1 This analysis focuses on economic ownership, which is based on ultimately bearing the costs and risks of

the asset (Barzel, 1997).

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Assigning economic ownership of FSAs to the parent and/or affiliate(s) reduces

free-rider problems that would arise if no entity within the firm had ownership rights to

the FSAs it created. If the FSAs were treated as pure public goods within the firm, there

would be no incentive to innovate, since the affiliates that bore no costs of developing the

FSAs would have access to the knowledge assets developed elsewhere within the firm.

When MNC entities own FSAs, they typically can determine the desired level of

investment in the FSAs and keep the profits earned from contracting or licensing the FSA

to other divisions of the firm. FSA owners are assigned responsibility and control over

decisions regarding the FSA and bear the operational risks associated with the

development, maintenance, and exploitation of the FSA.

Drawing on property rights theory, this study examines MNCs’ choices with

regard to FSA ownership structures. In general, it is expected that MNCs will select the

ownership structure that allocates FSA ownership and control rights to the division or

divisions whose marginal effort is most important with regard to developing,

maintaining, and reinvesting in the asset. For example, similar to Grossman and Hart’s

(1986) illustration of how client lists are owned in the insurance industry, FSAs, such as

customer relations and procurement know-how, are typically owned by the MNC unit

that deals directly with a particular set of customers or suppliers. However, in some

cases, the need for central coordination or the inability to monitor the actions of affiliates

will require greater involvement by the parent or headquarters in internal FSA

transactions. This study predicts that MNCs will choose to own FSAs that are more

“contractible” in the sense of being non-tacit, independent, and easy to describe, using

structures that engender more market-like incentives, but have less capacity for central

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coordination. In contrast, MNCs will choose to own FSAs that are tacit or

complementary, and are therefore less “contractible,” using structures that allow for

greater coordination and control.

Using a confidential new panel data set on the internal economic ownership of

FSAs and transactions within MNCs, four different types of FSA ownership structures

used by MNCs are identified: 1) sole, 2) shared, 3) separate, and 4) mixed. First,

approximately 35% of MNCs in the sample choose “Sole” ownership structures in which

a single entity (usually the parent or headquarters) owns all of the FSAs of the MNC.

Second, 18% of MNCs choose “Shared” ownership structures in which two or more

entities co-own all of the FSAs. In shared structures, it is often the case that the parent or

headquarters shares ownership of all of the FSAs with an affiliate. A third structure

chosen by approximately 42% of MNCs is “Separate” ownership in which different

affiliates of the firm own different FSAs. Separate structures generate greater market-

like incentives within the firm than shared or sole structures, but can be difficult to

coordinate. Finally, about 5% of MNCs choose “Mixed” structures in which the

ownership of some FSAs is shared and other FSAs is separate. While mixed structures

are more customizable, they are also the most difficult to manage. As previously

discussed, different FSA ownership structures not only trade off incentives and control,

but they also necessitate very different patterns of knowledge and financial flows within

the firm. Once a particular structure is chosen, it is costly and difficult to change, leading

to a low incidence of switching observed in the data (less than 4% of observations).

The key contribution of this research is the ability to shed light on the structure of

transactions for knowledge within firms. Due to data limitations, previous empirical

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research in economics and strategy has not been able to open up the black box of

internalized transactions. Although a great deal of research has examined the importance

of firm FSAs, little is known about the economic ownership of FSAs within the MNC.

This study identifies four ways in which MNCs structure ownership of their FSAs. The

four modes have different implications for control, coordination, incentives, and

knowledge sharing within the MNC. By examining how contracts for knowledge assets

are written and structured within firms, we gain insight into the ability of “incomplete

contracts” theories to explain internal firm behavior. Since contracts are so widely used

to delineate ownership of FSAs within firms, it seems likely that internalization is not

sufficient to deal with the difficulties inherent in contracting for knowledge.

From a policy standpoint, this research contributes to our understanding of the

kinds of benefits that foreign affiliates can bring to a local market. Affiliates that own the

MNC’s FSAs can accrue significant income from FSAs and have considerable strategic

determination over how the MNC’s key assets are developed, maintained, and deployed.

In this sense, ownership and control rights to FSAs are similar to subsidiary mandates

(e.g. Birkinshaw, 1996; Rugman, 1981). Additionally, some MNCs do choose ownership

structures as a way to minimize taxes. The results also shed light on the importance of

this aspect of MNC organization.

The next section describes FSAs in greater detail. The subsequent section presents

the literature review and predictions, followed by a description of the methods used to

test the predictions. The final section discusses the results and conclusions.

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FSAs and FSA Ownership Structures 4.2

FSAs are the MNC’s proprietary assets that provide the firm with a competitive

advantage. These assets are unique company strengths and include a broad range

technological, manufacturing, marketing, human, and organizational competencies and

know how (Rugman, 1981; Rugman and Verbeke, 1992, 2001). FSAs may originate

from the parent or the network of affiliates of an MNC.

In order to gain and sustain a competitive advantage from the FSAs, firms need to

continuously develop and maintain their FSAs (Peteraf, 1993). This requires a careful

balance between the need to generate market-like incentives that encourage investment in

FSAs with the need to coordinate knowledge-generating activities and allocate capital to

the highest-return investments throughout the firm. To this end, MNCs use four different

internal FSA ownership structures.

Section 3.2 provides a detailed description of the four different FSA ownership

structures. As discussed in Section 3.2, each of the four types of structures used by

MNCs to organize ownership of their FSAs has different advantages and disadvantages.

The following table summarizes the important features of the four structures.

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Table 6: Characteristics of FSA Ownership Structures

Sole Shared Separate Mixed

Control Over FSAs Centralized Shared De-centralized De-centralized

Risk Centralized into one

entity.

Shared by owners. De-centralized - risks

associated with

different activities

separately borne by

different owners.

De-centralized - mix of

shared and separately

held risks.

Incentives for Value

Creation

One entity has full

incentive.

Co-owners are

incentivized to

contribute to the value

creation process

together.

Owners are incentivised

to develop and create

their own FSAs.

Co-owners incentivised

to contribute together,

separate owners

incentivised to create

their own FSAs.

Financial Returns of

MNC

Centralized into one

entity.

Shared between a few

owners.

Dispersed to different

owners.

Dispersed to different

owners and co-owners.

Bargaining Problems Low - one entity owns

all FSAs.

High - hard to

distinguish contribution

of each co-owner and

shared control can lead

to conflict over future

direction of FSAs.

Medium - separate

owners within the MNC

hold power.

High - mix of co-

owners and separate

owners may try to use

power in bargaining.

Administrative

Complexity

Low - efficiency from

having one entity

contact with all entities.

Duplication of efforts

low.

Medium - co-owners

contract different

entities, with simplicity

of splitting any residual

returns. Duplication of

efforts medium.

High - complex to track

all contracting

relationships and that

each entity receives its

appropriate return.

Duplication of efforts

high.

High - complex to track

all contracting

relationships and that

each entity receives its

appropriate return.

Duplication of efforts

high.

Knowledge Flows Moderate Most Intensive Least Intensive Moderate

Information

Connections to FSA

Owners

High density -

connections between all

non-owners and one

owner.

Moderate density - non-

owner ties split amongst

the co-owners. Two-

way connections

between co-owners.

Low density - non-

owner ties to owners.

No/limited connections

between owners.

Moderate density - non-

owner ties split amongst

the owners and co-

owners. Two-way

connections between co-

owners, no/limited

connections between

separate owners.

Frictions in

Information/

Knowledge/Financial

Flows

Low - primary problem

bounded rationality.

Information overload of

owner and inability to

keep tabs on operations.

Lowest - by sharing

ownership, can delegate

responsibility for

portion of business to

co-owner. Reduces

information overload

problem. Co-owners

can then coordinate

business operations

together.

High - owners have

limited incentives to

share information or

resources with other

group members.

Moderate/High - While

co-owners have

incentives to share

information and

knowledge with other

co-owners, separate

owners do not have

incentives to share.

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As discussed later in this paper, the regression models are at the enterprise level of

analysis, not at the affiliate level of analysis. Thus, it is beyond the scope of this

investigation to combine an analysis of MNC FSA ownership structures with location

choices. Therefore, the issue of locating ownership in a tax haven country is dealt with

by simultaneously estimating a model of structure choice with a model of the decision to

own FSAs in a tax haven. FSA characteristics are expected to be strongly associated with

FSA ownership structure choices. However, if the choice of ownership structure is

primarily motivated by the desire to minimize taxes, the simultaneous model that

includes the tax haven choice and the simple model of ownership structure choice should

have very different results.

Theoretical Background 4.3

To balance the need for motivation and coordination in FSA creation and

maintenance, firms use a number of mechanisms including job design, employee stock

ownership, and compensation (Holmstrom and Milgrom, 1991; Lambert, Larcker and

Weigelt, 1993; Wang et al, 2009). However, since performance can be difficult to

measure and monitoring is costly, Holmstrom and Milgrom (1994) argue that these

mechanisms enable only a very limited set of activities to be effectively rewarded. In

cases where these mechanisms fail to provide adequate incentives, Holmstrom and

Milgrom (1994) maintain that asset ownership can be a “broader, more powerful

incentive instrument” (p. 972) by enhancing the bargaining power of asset owners and

rewarding their investments in the asset. Property rights theory draws the same

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conclusions, suggesting that asset ownership provides control over and income from the

asset and thus will be the most efficient way to incentivize investment.

As discussed in Chapter 3, FSA ownership structures vary in the degree of

centralized coordination they enable by allocating all FSA ownership rights to a single

unit versus the “market-like” incentives they create by assigning FSA ownership rights to

dispersed units within the firm. Because sole ownership structures are particularly

advantageous for small firms and the largest firms, the choice is likely to primarily be a

function of firm size, rather than FSA type. Similarly, since firms with mixed structures

choose to own their FSAs both separately and shared between units, this paper does not

have strong theoretical predictions at the firm level as to why mixed structures would be

chosen over shared or separate structures. Therefore the predictions focus on the choice

to own FSAs separately, or in structures that allow two or more MNC entities to share

FSA ownership.

4.3.1 Property Rights, FSA Contractibility, and Ownership Structure

Teece (1986) argues that firms exist to capture the returns from complementary

activities. However, when different units of the firm work together, conflicts and

bargaining problems can arise with regard to how to divide the returns – particularly

when the complementary activities involve knowledge creation. Holmstrom and Roberts

(1998) write, “Information and knowledge are at the heart of organizational design,

because they result in contractual and incentive problems that challenge both markets and

firms (p. 90).” Although integrated firms might be in a better position than independent

organizations at capturing the returns from knowledge transfers, “the problem of

knowledge transfers can be viewed as part of the more general problem of free-riding

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when independent parties share a common asset” (Holmstrom and Roberts, 1998: p. 91).

When free-rider problems arise, incentives to invest in knowledge creation are muted.

Investment distortions arise, in part, because the ownership of non-human assets

affects the incentives to invest in human and other intangible assets such as marketing,

relationships, and knowledge creation (Hart and Moore, 1990; Feenstra and Hanson,

2005; Holmstrom and Roberts, 1998). It is costly and difficult to measure and evaluate

investments in intangibles, and frequently, it is not clear ex ante how much and what

kinds of investments in these assets are the most appropriate. Thus, contracts for the

provision of services related to human and intangible assets (FSAs) are nearly always

incomplete – even within firms (e.g., Grossman and Hart, 1986; Hart and Moore, 1990).

When it is not possible to write complete contracts and bargaining is costly, property

rights theory suggests that assigning FSA ownership to the relevant entities within the

firm will mitigate investment distortions. According to property rights theory, the

“relevant” entity to which FSA ownership and control rights should be assigned is the

entity that is in the best position to make important investments in the FSA (Grossman

and Hart, 1986).

Although assigning property rights to FSAs can help resolve hold-up problems

stemming from incomplete contracts, firms face several trade-offs related to using this

mechanism internally. First, assigning property rights can potentially impede knowledge

sharing within the firm to the extent that they serve as a “pay wall” to important firm

know-how. In this sense, assigning property rights within firms clearly diminishes some

of the potential benefits of internalization. For example, if a firm’s knowledge cannot

flow freely within its own boundaries internal spillovers from knowledge creation will

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surely be attenuated. As discussed in the previous section, some FSA ownership

structures actually constrain the type and direction of knowledge sharing within firms.

Second, some kinds of knowledge assets are more “contractible” than others. When

complete contracts cannot be written that outline all possible rights and responsibilities of

FSA owners, the same kinds of contracting problems that occur at the boundaries of the

firm are likely to occur within firms.

The degree to which goods, services, and assets are “contractible” is related to how

easily they can be observed, separated, measured, or evaluated, and whether they require

relationship-specific investments and investments in intangibles. By definition, it is

easier to write complete contracts for goods, services, and assets that are more

“contractible.” Because markets provide stronger incentives for performance than firms,

transaction cost theory predicts that when complete contracts can be written, transactions

are more efficient when undertaken by independent parties in markets. In empirical

research on transaction cost theory, there is considerable evidence that contractible goods

or services are more likely to be exchanged in markets, rather than within firms (i.e.,

“bought” rather than “made”) (see, e.g. Anderson and Schmittlein, 1984; Masten, 1984;

LaFontaine and Slade, 2007). Property rights theory and empirical research comes to

analogous conclusions (see, e.g., Lerner and Malmendier, 2010; Elfenbein and Lerner,

2003; Kaplan and Stromberg, 2003). According to this literature, when complete

contracts cannot be written, market-like incentives can be achieved by assigning

“residual rights” ownership of important productive assets to the entity that is best

positioned to decide how the assets should be used. The assumption that problems

related to incomplete contracts can be resolved by exchange within firms is much

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stronger in transaction cost theory than in property rights theory (Grossman and Hart,

1986).

Citing Kitch (1980), Burk and McDonnell (2007) suggest that the importance of

assigning property rights is particularly relevant for knowledge-intensive goods for which

complete contracts can almost never be written:

“[P]roperty rights in intangible information serve to solve the ‘disclosure

paradox’ recognized by Kenneth Arrow: once the innovator discloses its idea to

the would-be developer, there is no reason left for the latter to compensate the

former, but before disclosure of the idea, the developer does not know what it is

worth. This creates a potential stand-off, in which the innovator is unwilling to

disclose without assurances of payment, but the developer is unwilling to give

assurances until disclosure. This scenario can be identified as an extreme

variation on the hold-up problem in transaction cost economics... (p. 584).”

The difficulties in contracting for FSAs are similar to those that arise in

transactions for knowledge. Because FSAs are often intangible and are costly to develop

and maintain, firms have an interest in creating internal structures that provide high-

powered incentives to invest in FSAs. Separate FSA ownership structures share many of

the same features as markets. They provide strong incentives for FSA-owning units

within the MNC to create and maintain FSAs. These structures grant the FSA-owning

units decision and control rights to the FSAs and require these units to undertake the

associated risks. In return, FSA-owning units have the right to keep residual profits

associated with their endeavors. Because ownership of FSAs is dispersed throughout the

firm and control rights are disaggregated, separate structures trade off central control and

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coordination for high-powered incentives to innovate. MNCs will be willing to make this

trade-off when FSAs are more contractible. When FSAs are easy to measure, observe,

and evaluate, structures that allocate FSA ownership and control rights to these entities

will generate fewer investment distortions.

When FSAs are difficult to measure, observe, or evaluate, or when FSAs require

knowledge inputs from more than one unit within the firm, structures that enable units to

collaborate and monitor each other’s inputs are likely to generate fewer investment

distortions. In contrast to separate structures, shared structures allow the MNC to reap

the maximum benefit from complementary assets. In this sense, shared structures trade

off market-like incentives for coordination and control. In shared structures, costs, risks,

and responsibilities for FSA creation and maintenance are shared by two or more units

within the firm and these units share residual profits generated by the FSAs. Knowledge

flows freely between units that co-create FSAs, and “pay walls” do not exist between

entities that share FSA ownership rights. Although property rights theory argues that

joint ownership of assets is never optimal in that it grants veto rights over assets to more

than one entity (Hart and Moore, 1990; Holmstrom and Roberts, 1998), it also it also

states that “assets that are worthless unless used together should never be separately

owned” (Holmstrom and Roberts, 1998: p.78).

Applying this insight to asset ownership within firms, firms are expected not to use

separate ownership structures when FSAs require inseparable contributions by more than

one entity within the firm. Contributions may be inseparable due to problems of

measurement and observability, or they may be inseparable in the sense of having no

stand-alone value. In cases of nonseparability, contracts detailing FSA ownership rights

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will be nearly impossible to design and, therefore, separate FSA ownership structures will

distort incentives for investment.

Property rights theorists might argue that sole structures would be superior to

shared structures in cases of extreme non-contractibility. In markets, shared owners such

as alliance and joint venture partners can destroy a venture if conflicts arise with regard

to value creation and profit sharing. These conflicts are important reasons why so many

shared ownership arrangements like joint ventures ultimately fail (Park and Russo, 1996).

However, within firms, using sole FSA ownership structures when non-contractible

contributions are required by more than one division can be very costly with regard to the

lack of incentives these structures give to non-FSA-owning units. Hierarchies facilitate

the use of shared asset ownership in important ways that markets do not. First, the parent

entity can intervene to resolve intra-firm disputes, making it possible to avoid worst-case

scenarios that can occur when affiliates share ownership of intangibles. Second, MNC

parents are often FSA co-owners in shared structures, which further reduces the potential

for costly disputes (since one of the owners has the power of fiat). Indeed, recent

literature on property rights theory questions the premise that joint ownership is never

optimal and suggests that in some cases, the gains from sharing ownership outweigh the

potential costs (e.g., Hart 1995; Matouschek, 2004). Since hierarchies resolve many of

the potential hold-up costs related to sharing ownership, it is expected that firms will be

more likely to use shared structures if the firms’ FSAs are less contractible. Shared

ownership of complementary assets creates incentives for the FSA co-owners to invest to

increase the total value of the asset. Thus, Shared ownership structures are likely to be

superior to Sole ownership structures.

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Hypotheses 4.4

Two dimensions of FSA contractibility— the independence versus

complementarity of the FSA and the codifiability versus tacitness of the FSA— are

expected to be associated with MNC decisions with regard to FSA ownership structures.

These are shown in the following matrix.

Table 7: FSA Contractibility

Structure Choice

FSA Contractibility Dimension Shared

Structure

Separate

Structure

Continuum 1:

Independent FSAs √

Versus

Complementary FSAs √

Continuum 2:

Tacit FSAs √

Versus

Codifiable FSAs √

4.4.1 Independence versus Complementarity

Independent assets are non-synergistic assets (Hart and Moore, 1990). They are

often idiosyncratic to different parties. When FSAs are “independent,” separate

ownership structures will be superior to all other ownership structures. Separate

ownership structures provide market-like incentives for developing and maintaining the

FSAs to the entities within the firm that are best positioned to invest in the FSAs.

Because no additional value is created from common ownership, the costs associated

with shared control are expected to outweigh the benefits.

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In MNCs, there are two potentially different reasons why some FSAs are more

independent than others. First, some FSAs are clearly related to the local operations of

individual foreign affiliates and are not related with FSAs developed by other units of the

firm. This is often the case with FSAs like customer relationships and services. Second,

some FSAs do not require the contributions of more than one entity within the firm. This

is often the case with process-related FSAs that may be intentionally or accidentally

discovered as a result of variation in routines within a particular unit of the firm (Nelson

and Winter, 1982).

In contrast, complementary assets provide synergistic value. As discussed above,

when FSAs are complementary, separate ownership structures are never optimal. Thus,

the following hypothesis is advanced:

Hypothesis 1: MNCs with independent (complementary) FSAs will be

more likely to have Separate (Shared) ownership structures and less likely

to have Shared (Separate) ownership structures.

4.4.2 Tacitness versus Codifiability

Tacitness refers to the extent to which knowledge or some knowledge-based asset

is non-codifiable and requires application to be observed. Research on the knowledge-

based view of the firm (KBV) has given significant emphasis to the problems inherent in

transferring tacit knowledge (e.g., Grant, 1996; Kogut and Zander, 1992, 1993; Teece,

1977; Martin and Solomon, 2003). Tacitness is perhaps the most important feature of

knowledge contractibility. When knowledge is embedded in complex routines and

decision rules, the cost of transferring it can become prohibitively high, effectively

making it non-contractible. Tacit knowledge has been found to significantly increase the

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costs of transferring knowledge abroad (Teece, 1977), to reduce the perceived ease of

internally transferring specialized marketing know-how (Simonin, 1999), and to increase

the time it takes to make new knowledge work well after it has been transferred

(Galbraith, 1990).

When the knowledge underlying FSAs is more tacit, FSAs are less contractible. In

such instances, MNCs will be less likely to use separate structures to allocate FSA

ownership rights. Since separate structures create mini firms within the MNC, these

structures enhance the difficulty of measuring and monitoring affiliates’ contributions

and the difficulty of transferring knowledge across the firm. To the extent that some

FSAs are more difficult to measure and evaluate in the first place, the problems inherent

in separate structures will be exacerbated.

Hypothesis 2: MNCs with tacit (codifiable) FSAs will be more likely to

have Shared (Separate) ownership structures and less likely to have

Separate (Shared) ownership structures.

Methods 4.5

4.5.1 Data

To examine the predicted relationships, a new confidential panel data set on

internal FSA ownership and transactions within MNCs was used. The dataset was

compiled from several sources. First, information on the types of FSAs owned by the

MNCs and the FSA ownership structures were taken from transfer pricing reports from a

consulting firm. MNCs are required by tax authorities to document their intra-firm

transactions each year in transfer pricing reports that determine whether or not the intra-

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firm transactions are at market price.2 The transfer pricing reports discuss in detail the

contractual relationships and transactions between MNC entities, the FSAs owned by the

MNC entities, and the activities performed by each entity in the transactional

relationship. Second, MNC financial data was gathered from Bureau Van Dijk’s Orbis

database. The Orbis database contains income statement, balance sheet, business

segment, and industry information on public and private firms located worldwide. For

every observation, the Orbis data was verified with the same financial information

contained in the transfer pricing reports. In cases where data were missing or in the very

few cases in which the Orbis data and the transfer pricing data contained different values

for the same financial information, data from the transfer pricing reports was used.

Third, merger and acquisition data for each MNC was collected from Thomson Financial

Worldwide Merger and Acquisitions database. The database covers both public and

private acquisitions.

4.5.2 Sample

Before discussing the construction of the panel, it is worth noting that there are

obvious sample selection biases related to the data source. All MNCs in the sample

sought the services of a consulting firm that specializes in advising MNCs with regard to

2 According to U.S. Treasury Regulations Section 1.482, Organization for Cooperation and Development

(OECD) Transfer Pricing Guidelines and various other local country requirements, MNCs must document

each year their intra-firm transactions in transfer pricing reports. Although documentation requirements are

country-specific, many countries follow the OECD Guidelines for transfer pricing and most countries

require that all material related-party activities are documented contemporaneous with the firm’s tax filing

(E&Y, 2013). The purpose of transfer pricing reports is to test whether or not their intra-firm transactions

are at market price and then document the analysis and results in the reports. In order to test that the

internal transfer price for each transaction is consistent with the external market price, the activities

performed by the MNC entities, their risks, and the economic ownership of intangible assets must be taken

into account. Therefore, the transfer pricing reports provide detailed descriptions of the products and

services, intangible assets owned, and activities performed by the entities. Intra-firm agreements are

typically included as appendices to the reports.

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transfer pricing strategies and other related activities. However, many MNCs seek the

services of such firms and all MNCs with material intra-firm transactions have to compile

transfer pricing reports. While many of the largest MNCs have well-staffed internal legal

and tax departments, they still seek the advice of consulting firms on transfer pricing

issues. Thus, the sample of firms is believed to not be unusual, given that they have all

chosen to be multinational and to have networks of foreign affiliates.

The raw sample contains data on 102 MNCs over the 2000-2012 time window.

Altogether there are 672 organization-year observations on the 102 MNCs. The number

of years of data for each MNC ranges from three to 13 years. Orbis had financial

information on 514 of the 672 MNC-year observations. In order to avoid unnecessary

loss of observations in the sample, data were entered from the company consolidated

financial statements used for the transfer pricing reports when Orbis data were missing.

Consolidated financial data were missing for 80 observations, leading to a total of 592

MNC-year observations after merging the financial and FSA ownership data. Lagging

the independent variables reduced the sample by 94 observations. The final sample

contains 498 MNC-year observations on 93 MNCs.

The data was coded and compiled under strict confidentiality. For this reason, no

company names or company-specific information can be identified. Therefore, only

means, standard deviations, percentages, and other statistical measures are reported and

all qualitative examples are redacted to disguise identity.

The sample comprises a diverse group of MNCs. The firms in the sample operate

in a broad range of industries including consumer goods, pharmaceutical, semiconductor,

retail, and financial service firms. Approximately 76 percent of the MNCs in the sample

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were headquartered in the United States, 15 percent in Europe, two percent in Asia, and

the remaining seven percent were headquartered in other regions. A total of 20 percent of

the firms in the sample are private. There is large variation in the size of MNCs in the

sample, with a heavily right-tailed distribution. The sample average MNC revenue is

USD 11.0 billion, with a standard deviation of USD 37.9 billion.

4.5.3 Level of Analysis

The analyses are at the MNC-level, rather than the affiliate level. Thus, although

the data contains information on whether the parent and/or particular affiliates own FSAs

and the extent to which the FSAs are contracted out or licensed across the firm, all the

financial data, FSA data and MNC structure data are at the MNC-level.

4.5.4 Variables

Dependent Variable

FSA Ownership Structure is operationalized as a categorical variable, coded 1 for a

Sole ownership structure, 2 for a Shared ownership structure, 3 for a Separate ownership

structure, and 4 for a Mixed ownership structure. Four binary indicators for each

ownership type were also created. These mutually-exclusive categories were coded

based on the detailed descriptions of FSA ownership provided in the transfer pricing

reports. Chapter 3 contains the definitions used to code the ownership structures and

examples of the qualitative descriptions of ownership that MNCs include in their transfer

pricing reports.

Independent Variables

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MNC FSAs and Contractibility Dimensions. The transfer pricing reports contain

lengthy qualitative descriptions of the FSAs owned by the MNC. Underpinning these

FSAs are flows of licensing revenues between MNC entities. Thus, transfer pricing

reports describe the bundle of skills, knowledge, routines, processes, technologies,

patents and other firm value-drivers that are owned or co-owned by one or more entities

and contracted or licensed to other entities within the firm.

There are several ways to create the key explanatory variables from the data used

in this research. First, one can identify the types of FSA(s) owned by each MNC using

the detailed descriptions. The problem with this approach – although this study reports

robustness results that use this approach – is that firms’ often identify more than one

FSA. For example, a firm might indicate that its primary source of value is its ability to

create new products as well as the brands and trademarks that it currently owns. In this

simple case, it is not clear whether the firm’s primary FSA is product innovation or the

brands and trademarks it owns or both. The initial version of this paper analyzed four

FSA categories (1) Manufacturing Processes, (2) Expertise and Relationships, (3) Product

Innovation, and (4) Brands. Chapter 3 Table 1 provides qualitative examples of MNCs’

FSA descriptions.3 Each MNC was assigned as many FSA categories as the descriptions

conveyed. Thus, the firm above would have been categorized as having “Product

Innovation” and “Brands” FSAs. This labeling scheme is problematic for two reasons.

First, in some cases there may be only one identifiable revenue flow (from licensing or

contracting) associated with the bundle of FSAs, thus naming more than one FSA

3 An alternative approach is assigning each firm to a unique FSA category based upon the description in the

transfer price reports. A drawback to this approach is that it is often not straightforward which skill, asset,

process, technology, etc. is the “primary” value-driver of the firm.

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category causes identification problems. Second, from a theoretical standpoint, Product

Innovation was considered to be more tacit and Brands to be more codifiable, so it is not

clear which structure would be predicted from theory. Despite the problems with this

approach, it is used here primarily for the sake of illustrating interesting properties of the

data.

A second approach, used here, is to remain agnostic as to what the FSAs actually

are and instead use the FSA descriptions to code the features of the MNC’s bundle of

FSAs. Word counts were used to construct the two hypothesized contractibility

dimensions (tacit vs. codifiable and independent vs. complementary). A list of potential

words was created for each end of the two dimensions (tacit and codifiable for Tacit

Scale and independent and complementary for Independent Scale). The words and

phrases were selected to be consistent with prior research (e.g., Zander and Kogut, 1995;

Ambrosini and Bowman, 2001; etc.). Then the list of words was narrowed down through

several iterations of reading FSA descriptions and adding and removing words from the

lists. The lists were narrowed by eliminating duplicate words, words that were only used

once or twice, or words that were often used to mean many different things. Once the

word list was created, the relevant sections of the transfer pricing reports were searched

for each of the listed words in the descriptions to form preliminary counts of “Tacit,”

“Codifiable,” “Complementary,” and “Independent” words. For example, in the phrase,

“…these new innovations are fundamentally distinct from, and do not rely upon, the

technologies used in the past….” the word “innovations” would be counted as tacit and

the word “distinct” would be counted as independent. The count of words was then

cleaned by reviewing the text again to ensure that, for example, words like “suite”

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referred to a suite of products or applications rather than an address. In cases where the

words were out of context, the count was changed to exclude the irrelevant observations.

The following table contains the final list of words.4

Table 8: Contractibility Dimension Word Counts

After finalizing the word counts, scales were created from the word counts for the

two contractibility dimensions (Jap, Robertson, and Hamilton, 2011). Independence

Scale, was calculated as the total count of independent words minus the total count of

4 In robustness tests, words that could be tied to an organizational structure were removed from the scale

such as cross-functional, different, business segment, and standalone. The results to the analyses did not

change by removing the words.

Tacit Total Count Codifiable Total Count

expertise 475 trademark 3021

experience 1039 trade name 704

know-how 340 logo 219

knowledge 441 blend 360

trade secret 115 formula 1778

explore 38 recipe 75

innovat 1089 compound 1379

technology 8717 manual 383

solutions 2906 patent 2257

complex 1584 schematic 120

Tacit Scale

Complementary Total Count Independent Total Count

collaborat 431 standalone 161

combin 2043 separate 905

integrat 2859 used only, used primarily in 35

common 497 distinct 220

cross-functional 78 specialized 473

bundle 64 custom 907

companion 29 differentiated 83

complement 349 diversified 85

unified 373 -specific 69

suite 383 business segment 320

Independent Scale

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complementary words divided by the natural log of total words searched. A positive

value of Independence Scale indicates that the MNC’s bundle of FSAs is independent,

whereas a negative value indicates that the MNC’s FSAs are complementary. Similarly,

Tacit Scale is measured as the total count of tacit words minus the total count of

codifiable words divided by the natural log of total words searched. A positive value of

Tacit Scale indicates that the MNC’s FSAs are tacit, whereas a negative value indicates

that the MNC’s FSAs are codifiable.

Control Variables

Firm Size. Firm Size is operationalized as the natural log of the total number of

MNC subsidiaries, lagged by one year. Small MNCs are expected to be more likely to

have a Sole ownership structure and larger MNCs are expected to be more likely to have

Shared, Separate, or Mixed structures. The number of subsidiaries is used as a measure

of size rather than assets or sales because the complexity of the MNC rises with affiliate

network size. To show this, the squared number of MNC subsidiaries is also included.

As complexity increases with network size, the administrative costs of the more complex

structures rise dramatically. Therefore, the largest MNCs are expected to use sole

ownership structures to reduce organizational costs. Thus, the number of subsidiaries is

expected to be negatively associated with sole ownership, and the squared number of

subsidiaries is expected to be positively associated with sole ownership. Firm Size and

Size Squared are mean-centered in the regression estimates.

R&D Intensity. MNC R&D Intensity is included in order to take into account the

relationship between innovation activities and structure choice. R&D Intensity is

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measured as total MNC R&D expenditures in the prior year divided by MNC total

revenue in the prior year. MNCs in the sample had an average R&D Intensity of 12

percent. This measure is expected to be positively associated with Shared and Mixed

ownership structures.

Diversification. A one-year lagged total entropy diversification measure is used to

capture the diversity of a firm’s activities (e.g. Bowen and Wiersema, 2005; Palepu

1985). The variable is calculated as follows:

Total Entropy = ∑

Si represents the MNC’s share of total sales in business segment i. N represents

the total number of business segments in which the MNC operates. The measure is

calculated using the business segment information from Orbis and, in the case where

Orbis data was unavailable, from the consolidated financial data in the transfer pricing

reports. This variable equals zero for single business firms and increases with greater

levels of diversification. Diversification is expected to be positively associated with

Separate ownership structures since diversified firms are more likely to have independent

FSAs.

Number of M&As. An acquisition event is defined in this study as an MNC

acquiring or merging 100 percent with a target firm.5 The variable is calculated as the

sum of the total number of acquisitions and/or mergers that an MNC made in the prior

year. On average, the MNCs in the sample engaged in one M&A in a given year, with a

standard deviation of 2.38. The number of acquisitions made by the MNC each year is

5 In results not reported herein, the alternative definition of acquiring greater than 5% of a company was

used. The alternative definition of acquisitions did not alter the results.

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included as a control for reasons similar to diversification. Since post-merger integration

is costly and complex, MNCs that undertake a greater number of acquisitions are

expected to be more likely to allow acquired firms to manage their own FSAs. Thus, the

Number of M&As should be positively associated with Separate or Mixed structures.

Tax Haven Ownership. Tax Haven ownership is a binary indicator variable, set

equal to one if the MNC has at least one FSA owner incorporated in a tax haven. Tax

Haven countries were identified based on the list of tax haven countries (Dharmapala and

Hines, 2007). Additionally, the binary indicator Pure Tax Haven was created to indicate

whether the MNC had a tax haven FSA owner with no real operational activities.6

All regressions include controls for time using a time trend and industry using

dummy variables for Manufacturing, Service, and Other industries. All independent

variables are lagged by one year.

4.5.5 Estimation

The hypotheses focus on the degree to which MNCs are more likely to own

independent (versus complementary) FSAs in Separate or Shared structures and tacit

(versus codifiable) FSAs in Separate or Shared structures. Therefore the main analyses

focus on firms’ decisions to use Separate or Shared ownership structures.

The analysis has three parts. First, a probit model of the choice between Shared

and Separate structures is estimated, excluding firms that use Mixed or Sole structures.

6 The indicator for Operational Tax Haven is set equal to one if the tax haven FSA owner performed at

least one of the following functional activities: R&D, manufacturing, distribution, sales and marketing

activities, or financial trading (for banking firms). The binary indicator variable Pure Tax Haven is set

equal to one if the firm’s tax haven FSA owner did not physically perform operational activities, defined as

R&D, manufacturing, distribution, sales and marketing activities, or financial trading (for banking firms).

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Second, using the same sub-sample, a bivariate probit model is estimated that combines

the choice between Shared versus Separate structures and the choice to have an FSA

owner located in a Tax Haven. It is expected that these are endogenous and interrelated

decisions. The bivariate probit, which is a variation of the standard Heckman model,

allows for estimating the two decisions together. It is expected that there will be different

results between the bivariate probit model that includes tax haven choice and the simple

probit model if the choice of ownership structure is primarily motivated by the desire to

minimize taxes.

Third, as an exploratory analysis, the multinomial logit is used to examine the

choice set of FSA ownership structures.7 All of the models have the following general

specification:

Yit = αi + β1Xi(t-1) + β2Zi(t-1) + φj + τt + εit

Yit is the discrete choice, either between Shared or Separate FSA ownership

structures or between all four structures in the multinomial logit estimates. The bivariate

probit model adds a second Yit which is set equal to 1 if the MNC has Tax Haven FSA

owner(s).

β1Xit is a matrix containing each MNC’s scores for the Independent Scale and the

Complementary Scale, and β2Zi(t-1) is a matrix containing lagged MNC characteristics, in

particular, Firm Size and Size Squared, R&D Intensity, Diversification, and the Number

7 The multinomial logit estimates are problematic due to the fact that (1) the choice processes for the

different structures are not the same (e.g., firms do not go directly from Sole to Mixed) (2) some FSA

ownership structures can be viewed as substitutes for each other (e.g., Mixed ownership structures might be

used as a substitute firms choosing to change from Shared (Separate) to Separate (Shared) ownership

structures). Thus, the inclusion of Mixed structures clearly violates IIA. Therefore this study reports

multinomial logit results on a truncated sub-sample of MNCs that excludes 37 firm-year observations of

Mixed ownership structures.

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of M&As. φj and τt are industry and year controls, respectively. All errors are

clustered to account for repeat observations on MNCs.

Results 4.6

4.6.1 Descriptive Statistics

Table 9: Mean MNC Characteristics and FSAs by FSA Ownership Structure

The table above contains the mean values of MNC characteristics by FSA

ownership structure. Superscripts 1-4 denote significant differences between structures.

Thus, the statistics for revenue can be interpreted as follows. The average of the natural

log of revenue for MNCs using a sole structure is 12.62. The superscripts 2, 3, 4 indicate

that 12.62 is significantly different from the corresponding values for all of the other

structures. The average of the natural log of revenue for MNCs using a Shared structure

is 13.41 and the superscripts 3 and 4 indicate that 13.41 is significantly different from the

corresponding values in Separate and Mixed ownership structures. Looking down the

table, there are large differences in some of the variables for each structure. For example,

MNCs using Sole and Shared ownership structures are much more R&D intensive than

All Mixed

MNC Characteristics (1) (2) (3) (4)

Revenue 13.92 12.622,3,4

13.413,4

14.704

15.83

Number of Subsidiaries 3.63 2.912,3,4

3.343,4

4.024

4.94

R&D Intensity 0.13 0.162,3,4

0.193,4

0.08 0.10

Profitability -0.05 -0.133,4

-0.234

0.06 0.12

Effective Tax Rate 0.26 0.25 0.24 0.28 0.19

Diversification 0.32 0.213,4

0.203,4

0.364

0.90

Age 41.66 32.462,3,4

24.923,4

57.564

19.34

Sole Shared Separate

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MNCs using Separate or Mixed structures. MNCs using Mixed ownership structures pay

the lowest average effective tax rate, and they are also the most profitable on average.

Table 10: Descriptive Statistics and Correlations8

Table 10 contains descriptive statistics and correlations for the full sample of

MNCs. The highest correlation is between Firm Size and the Number of M&As (r=0.44).

Therefore, M&As and diversification are entered into the regressions separately from

Firm Size.9

Chapter 3 – Figure 7 shows the distribution of FSA ownership structures by

industry. Interestingly, 100% of MNCs in the finance, insurance, and real estate

industries use Separate ownership structures. Similarly, approximately 50% of MNCs in

the wholesale trade and legal, education, and engineering services industries also use

Separate ownership structures. The very high prevalence of Separate ownership

structures in the services industries can be attributed to the fact that services are often

8 The correlation matrix is calculated using 2007 single-year data since standard cross-sectional correlations

assume independence across observations. The correlation matrices for the pooled sample and for the other

single years were consistent with those shown in the correlation table above. 9 Entering all variables into the equation does not change the results for the primary variables of interest.

Mean s.d. 1 2 3 4 5 6 7 8 9

1 Shared 0.21 0.41

2 Tacit Scale 1.19 3.48 0.25*

3 Independent Scale -0.70 1.24 -0.33* -0.35*

4 Firm Size 0.18 1.32 -0.15 -0.17 0.19

5 R&D Intensity 0.12 0.19 0.10 0.14 -0.21 -0.35*

6 Number of M&As 1.00 2.38 -0.08 0.02 0.10 0.44* -0.10

7 Diversification 0.29 0.45 -0.09 -0.01 0.08 0.28* -0.10 0.08

8 Manufacturing Dummy 0.66 0.48 -0.17 -0.05 0.00 0.09 0.09 -0.09 0.14

9 Other Industry Dummy 0.09 0.29 0.10 -0.14 0.08 -0.07 -0.20 -0.11 -0.10 -0.43*

10 Tax Haven Dummy 0.49 0.50 0.37* -0.07 -0.07 0.34* -0.22 0.18 -0.03 -0.11 0.00

* p<.05. Year=2007. Number of Observations 67.

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independent and tied to local markets. Thus, Separate structures give FSA ownership

rights to the affiliates that are best positioned to invest in these competencies.

Figure 9: Ownership Structure by Type

Figure 9 presents the distribution of FSA ownership structures in the sample and

the proportion of firms using each structure that have a pure tax haven FSA owner. Not

surprisingly, MNCs with Sole structures almost never allocate FSA ownership rights to

pure tax haven affiliates. Pure tax haven use is much more prevalent in Shared

ownership structures (55% of observations) as compared to Separate ownership structures

(11% of observations). MNCs using Mixed ownership structures are the most prolific

users of pure tax haven subsidiaries (59% of observations).

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

40.0%

45.0%

Sole Shared Separate Mixed

Per

cen

tag

e

FSA Ownership Structure

FSA

Ownership

Structure

Portion of

MNCs with

Pure Tax

Haven

Owner(s)

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Figure 10: Percentage of FSA Types Shared vs. Separate

Figure 10 shows the FSA categories and the degree to which they are owned in

Shared versus Separate structures. The bars on the chart represent the percentage of total

observations that have Shared versus Separate ownership structures. Some fascinating

results emerge. First, 100% of MNCs with Manufacturing Process or Expertise and

Relationship FSAs use Separate ownership structures! The FSAs with 100% Separate

ownership fit with Hypothesis 1 in that these FSAs are typically independent. Thus,

these FSAs are expected to be separately owned. Consistent with Hypothesis 2, MNCs

with tacit FSAs like product innovation are much more likely to use Shared than Separate

ownership structures.

As discussed above, three different estimation techniques were used to test the

hypotheses. Table 11 reports the probit results with the dependent variable set equal to 1

for Shared ownership structure. MNCs with Sole and Mixed ownership structures are

excluded from these estimates. Column 1 contains the control variables Firm Size, Size

Squared, R&D Intensity, the time trend and dummies for Manufacturing and Other

industries (Service industries is the referent category). Column 2 contains simple probit

estimates of the base model with the Tacit and Independent scales added. The pseudo-R2

more than doubles when the two FSA dimension scales are added. Column 3 shows the

Manufacturing Processes

Expertise and Relationships

Product Innovation

Trademark and Marketing

Shared Separate

100% 80% 60% 40% 20% 0 20% 40% 60% 80% 100%

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estimates of the base model with Firm Size and Firm Size Squared removed and Number

of M&As and Diversification added. Columns 4 and 5 contain the bivariate probit

estimates with the same independent variables as Columns 2 and 3, respectively. Finally,

Columns 6 and 7 show the bivariate probit estimates using FSA categories as explanatory

variables rather than FSA dimensions. The last two regression models can only be

estimated using two of the four FSA categories since 100% of MNCs with

“Manufacturing Process” FSAs and “Expertise and Service” FSAs use Separate

structures.

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4.6.2 Regression Results

Table 11: Probit and Bivariate Probit Results Predicting Shared FSA Ownership

The estimates in Table 11 provide strong support for Hypotheses 1 and 2. In the

probit estimates and bivariate probit estimates in Columns 2-5, MNCs with Independent

FSAs are more likely to use Separate, rather than Shared ownership structures (p<.01)

and MNCs with Tacit FSAs are more likely to use Shared rather than Separate ownership

structures (p<.05). The estimated coefficients and standard errors for the two

1 2 3 4 5 6 7

H1 (-) Independent Scale -0.66** -0.73** -0.71** -0.80**

(0.25) (0.25) (0.26) (0.26)

H2 (+) Tacit Scale 0.20* 0.22* 0.19* 0.21*

(0.09) (0.09) (0.09) (0.09)

H1 (-) Brand -0.80* -0.60

(0.39) (0.39)

H2 (+) Product 3.04*** 2.76***

(0.71) (0.61)

Firm Size -0.31* -0.17 -0.19 -0.28†

(0.14) (0.14) (0.14) (0.15)

Firm Size Squared -0.16** -0.12† -0.12* -0.16*

(0.06) (0.06) (0.06) (0.07)

R&D Intensity 0.27 -0.41 -0.38 -0.48 -0.44 -1.04† -0.68

(0.61) (0.50) (0.51) (0.50) (0.50) (0.60) (0.59)

M&As -0.16† -0.17† -0.14†

(0.09) (0.09) (0.08)

Diversification -0.36 -0.47 -0.52

(0.40) (0.47) (0.39)

Trend 0.07† 0.03 0.04 0.05 0.05 0.04 0.05

(0.04) (0.04) (0.04) (0.04) (0.04) (0.04) (0.04)

Manufacturing Industry Dummy -0.69 -0.81 -0.81 -0.90 -0.82 -0.49 -0.16

(0.43) (0.56) (0.53) (0.56) (0.55) (0.48) (0.51)

Other Industry Dummy -0.61 0.13 0.12 0.11 0.14 1.68* 1.49*

(0.64) (0.70) (0.68) (0.66) (0.63) (0.67) (0.65)

Constant -0.43 -0.79 -0.85 -0.84 -0.93 -2.58** -2.72**

(0.57) (0.63) (0.57) (0.64) (0.59) (0.93) (0.86)

Number of Observations 348 348 349 348 349 348 349

Pseudo R-Squared 0.15 0.37 0.37

Wald Chi-Squared 24*** 30*** 31*** 44*** 43*** 46*** 39***

Log Pseudolikelihood -184 -136 -136 -319 -324 -309 -327

Wald Test of rho=0 (Chi-Squared) 5.30* 5.81* 9.04** 6.59*

Robust, clustered standard errors are in parentheses. Two-tailed tests for variable coefficients.

†p<.10; * p<0.05; ** p<0.01; *** p<0.001

Probit Bivariate Probit

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hypothesized scales show remarkable stability across the different probit and biprobit

regression estimates.

In general, smaller firms tend to have Shared rather than Separate ownership

structures, and R&D Intensity is not related to the choice of Shared and Separate FSA

ownership structures. MNCs that make a larger number of M&As are more likely to use

Separate ownership structures (p<.10, Columns 3 and 5), but Diversification is unrelated

to FSA ownership choice.

Turning to the estimates in Columns 6 and 7, MNCs with Product Innovation

FSAs are more likely to use Shared, rather than Separate ownership structures (p<.001)

and MNCs with Brand FSAs are somewhat less likely to use Shared ownership structures

(p<.05, Column 6; p>.10, Column 7). These results are consistent with the estimates in

Columns 2-5 in the sense that Product Innovation FSAs tend to be more tacit and less

independent, and Brand FSAs tend to be more codifiable and independent. However, the

estimates using FSA categories suffer from collinearity with the industry dummies, since

many of the FSAs tend to be prevalent in particular industries, so these results should be

interpreted with some caution.

The bivariate probit results in Columns 4 and 5 include a second set of regression

estimates for which the choice to have a tax haven subsidiary is the dependent variable.10

Although the estimates are not reported in the table, in all cases there was only one

significant association—a negative and significant relationship between the choice to

have a tax haven subsidiary and the Independent Scale (p<.05). This relationship is

10 The estimates in Columns 7 and 8 use the same bivariate probit regressors in the tax haven model. A

Likelihood Ratio Test for Independence of the two regressions was significant (p<.05), however the

bivariate probit specifications need further refinement.

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somewhat complex. The tax haven FSA owner bears the costs and risks of developing

the complementary FSAs and earns revenues from licensing the FSAs throughout the

MNC. In some cases, these tax haven FSA owners are in countries like Ireland and

Switzerland in which subsidiaries perform real activities and have real strategic

responsibilities. In other cases, tax haven FSA co-owners are in pure tax havens like

Cayman Islands, and the MNC parent makes all strategic decisions. Perhaps

complementary FSAs provide greater opportunities for taking advantage of tax havens

since they can be leveraged across the MNC’s assets. The results suggest that the choice

to use Shared versus Separate structures and the choice to have a tax haven affiliate are

interrelated. However, the results also show that real considerations, such as the features

of an MNC’s FSAs as well as Firm Size and M&A activity are important correlates of

structure choice.

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Table 12: Multinomial Logit Results

Table 12 reports the multinomial logit estimates. As discussed in footnote 7, these

estimates are exploratory and the sample is truncated by removing MNCs that use Mixed

FSA ownership structures. Despite this shortcoming, the multinomial logit results shed

light on interesting differences between MNCs using Sole ownership structures with only

one FSA-owning entity and MNCs using structures in which more than one entity owns

FSAs (Shared or Separate ownership structures). The results in Column 1 of Table 12 are

similar to the results in Table 11. Compared to MNCs that use Separate structures,

Shared

versus

Separate

Shared

versus

Sole

Separate

versus

Sole

1 2 3

H1 (-) Independent Scale -0.93† -0.12 0.80†

(0.50) (0.21) (0.47)

H2 (+) Tacit Scale 0.21* 0.11 -0.10

(0.10) (0.09) (0.08)

Firm Size -0.30 0.33 0.62**

(0.25) (0.26) (0.19)

Firm Size Squared -0.18 -0.36** -0.18

(0.12) (0.12) (0.12)

R&D Intensity -0.49 -0.55 -0.06

(0.68) (0.43) (0.42)

Trend 0.05 0.03 -0.02

(0.08) (0.09) (0.07)

Manufacturing Industry Dummy -0.71 -0.41 0.31

(0.85) (0.77) (0.53)

Other Industry Dummy 0.14 1.01 0.87

(1.10) (1.10) (0.88)

Constant -1.31 -0.12 1.19

(1.13) (1.08) (0.84)

Number of Observations 498

Wald Chi-Squared 56***

Pseudo R-Squared 0.21

Log Pseudolikelihood -412

†p<.10; * p<0.05; ** p<0.01; *** p<0.001

Robust, clustered standard errors are in parentheses. Two-tailed tests for

variable coefficients.

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MNCs that choose Shared ownership structures have FSAs that are more Tacit (p<.05,

Column 1) and less Independent (p<.10, Column 1). In Column 2, the only significant

difference between MNCs that choose Shared versus Sole ownership structures is that the

latter tend to be used by the largest MNCs in the sample. This is consistent with the idea

that as firms grow to be extremely large, FSA ownership structures that allow for

multiple FSA owners with joint control rights and their respective contracting

arrangements simply become too complex and difficult to manage.

The estimates in Column 3 compare the choice of Sole and Separate FSA

ownership structures. Interestingly, MNCs that choose Separate structures are larger, on

average than MNCs that choose Sole structures (p<.01, Column 3). However, the very

largest MNCs are equally likely to choose both structure types. Finally, consistent with

property rights theory, MNCs with Independent FSAs are more likely to choose Separate,

rather than Sole FSA ownership structures (p<.10, Column 3). This suggests that when

FSAs have no synergistic value, firms choose disaggregated ownership structures that

provide market-like incentives for FSA development and maintenance to individual

affiliates throughout the MNC.

Several robustness tests were performed to check the sensitivity of the results.

First, additional controls were included in the regressions such as a binary indicator for

whether the firm is a public or a private firm, binary controls for whether the MNC is

incorporated in the US, Europe, or elsewhere, and a control for host country effective tax

rate. Second, alternative measures were applied for some of the controls in the

regressions. For example, MNC number of subsidiaries was replaced with MNC

revenues as well as MNC total assets, Diversification was replaced with the total number

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of four-digit SIC codes in which the MNC operates and the Number of M&As was

replaced with M&A activity defined as acquiring greater than 5% of the company. Third,

highly correlated variables were entered into the regressions one at a time and also the

regressions were run without Firm Size Squared. The results of these additional analyses

on the theoretical variables of interest were consistent with the results reported herein.

Discussion 4.7

This study investigates how MNCs internally organize ownership of their FSAs.

The findings suggest that the problems associated with incomplete contracts are not fully

resolved by bringing an activity inside the firm. From the standpoint of property rights

and transaction cost theory, a key result of this research is that the same features of FSAs

that render them more or less contractible in markets also explain the internal ownership

structures chosen by firms.

In contrast to the assumption that knowledge assets are public goods within MNCs

(e.g., Ethier, 1986), firms establish internal economic ownership structures in which FSA

owners contract or license the FSAs to other affiliates and/or the parent. Such structures

allow firms to balance high-powered incentives that reward innovation with internal

coordination and control. This creates internal market-like transactions and structures

within the firm and, to some extent, limits the benefits of internalization, such as the

ability to freely access spillovers from internally created knowledge. Even within firms,

free rider problems disincentivize FSA creation and maintenance. Thus, some degree of

excludability is necessary for successful FSA development within firms. To this end,

MNCs choose different structures to delegate internal residual rights ownership of their

most important knowledge assets—including assets for which contracts are extremely

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difficult to write. Although these assets are considered to be non-contractible in markets

(e.g., Dunning, 1980), they are extensively contracted and licensed within MNCs.

This study identifies four different types of FSA ownership structures: sole,

shared, separate, and mixed. It is argued that the reason that these FSA ownership

structures exist is to balance motivation and coordination problems associated with

contracting for knowledge. This research draws on property rights theory to understand

the decisions that MNCs make with regard to the internal ownership of FSAs. Consistent

with the predictions, MNCs with independent and easily codifiable FSAs are more likely

to use separate ownership structures that provide high-powered incentives. In contrast,

firms with complementary and tacit FSAs are more likely to use shared ownership

structures that facilitate knowledge flows and coordination within the firm.

When FSAs are highly contractible, MNCs use separate structures, or “mini firms

within the firm,” to organize internal FSA ownership. In separate structures, individual

units within the firm own and control the FSAs in which they are best positioned to

invest. Separate structures are the most common choice of all the MNCs in the sample

and have several interesting features. First, they are chosen by the vast majority of

MNCs in service sector industries. Second, compared to Shared ownership structures,

Separate structures are much less likely to be used by firms that make extensive use of

pure tax haven FSA owners. Since Separate structures involve the delegation of

ownership along with decision and control rights to MNC affiliates, it is perhaps not

surprising that these rights are not often granted to pure tax haven units that perform no

other functions for the MNC.

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Third, Separate structures are chosen by 100% of MNCs with Manufacturing

Process and Expertise and Service FSAs. In addition to being independent, these FSAs

are likely to be organized in Separate structures because they tend to be localized. Future

drafts of this research will examine the association between the “local versus global”

dimension of FSAs and FSA ownership structure choices.

When FSAs are less contractible in the sense of being tacit or complementary,

MNCs choose Shared ownership structures. These structures are not very widely used by

firms in the sample – most likely due to the potential bargaining problems they create.

Shared structures allocate FSA ownership and control rights to two or more entities

within the firm, hypothetically giving all shared owners veto power over decisions related

to the FSA. The theoretical link between internal shared structures and the predictions of

property rights theory is complex. In general, property rights theory maintains that two

independent entities should not share ownership of complementary assets (Hart and

Moore, 1990).11

Rather, one entity or the other should own the assets and divide the

returns. Hart and Moore (1990) refer to this as “integration,” meaning only one entity

owns the asset. “Integration” is analogous to ownership in hierarchies rather than

markets. Within the firm, however, potential hold-up problems that arise due to the

shared veto issue are mitigated by the fact that the parent entity can always resolve

internal conflicts by fiat. Indeed, MNC parents are often FSA co-owners in the sample of

11 More recent work in property rights theory has taken issue with Hart and Moore’s position that joint asset

ownership is never optimal. Holmstrom and Roberts (1998) note that joint ownership may be more

efficient when investments by more than one entity improve non-human assets (p79). Within firms, this is

likely to be the case when investments are costly and capital intensive, requiring the participation of more

than one unit within the firm.

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firms, giving them even more power to settle disputes. Thus, within firms, many of the

potential drawbacks of shared ownership in markets are no longer problematic.

A key finding in this research is that within firms, shared ownership structures are

much more likely to be used when FSAs are tacit and complementary. In markets, shared

structures have the potential to maximize conflicts, whereas within the firm, they allow

for close coordination, knowledge transfers, and shared incentives to innovate. In this

sense, the ability to manage joint ownership arrangements when FSAs are tacit or

complementary or in cases where contributions of individual units within the firm are

difficult to measure, is one of the most important advantages of organization in firms

rather than markets.

Finally, in exploratory results this study examines the correlates of Sole ownership

structures. Consistent with the idea that sole ownership structures can reduce complexity

for very large firms, the results indicate that Sole ownership structures are chosen by the

largest MNCs in the sample. Additionally, firms choose Separate structures rather than

Sole structures when FSAs are independent. In such instances, Separate structures

provide better disaggregated incentives to develop and maintain the MNC’s FSAs.

It is important to note that all FSA ownership structures are the result of a two-step

process. First, ownership is “integrated” in the sense of being internalized within firms.

Second, the choice is made within the firm to integrate FSA ownership (Sole ownership),

share ownership between various units (Shared ownership), distribute FSA ownership to

“mini firms within the firm" (Separate ownership) or use some hybrid of the latter two

structures (Mixed ownership).

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The results indicate that the choice of Shared versus Separate ownership

structures is interrelated with the choice to have tax haven subsidiaries. The majority of

MNCs in the sample have tax haven subsidiaries, and many have tax haven FSA owners.

MNCs with Shared ownership structures have a larger proportion of pure tax haven FSA

owners than MNCs with any of the other three structures. It therefore is no surprise that

the Internal Revenue Service classifies shared ownership between US and foreign MNC

entities as a Tier 1 tax issue. The finding that MNCs with complementary FSAs are more

likely to have tax haven FSA owners suggests that FSA characteristics may be associated

with a firm’s ability to take advantage of tax havens.

Although a detailed analysis of firm strategy and its relation to FSA ownership

structure choice is beyond the scope of this paper, the results seem to suggest that Shared

structures are used by relatively young, innovative MNCs in high growth industries.

Compared to MNCs with Sole and Separate structures, MNCs that use Shared structures

are significantly younger and less profitable. Compared only to MNCs that use Separate

structures, MNCs that use Shared structures have fewer subsidiaries and undertake fewer

M&As. MNCs with shared ownership structures are much more prevalent among MNCs

with Product Innovation FSAs in areas such as software programming. These stylized

facts, together with the much greater use of pure tax haven FSA owners suggests that

MNCs with Shared structures may channel the revenues from FSA ownership to tax

havens in order to fuel global growth.

FSA ownership has implications for policymakers and managers alike. For

policymakers, internal FSA ownership and contract and licensing arrangements have

been the subject of much scrutiny lately by legislatures and governments around the

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globe (e.g. Levin and McCain, 2013; Bergin, 2012; Thompson, 2012). FSA ownership

has a significant effect on government revenues. Understanding the purpose and the

factors that drive the selection of FSA ownership structures can provide insight into the

types of policies that can attract MNCs to locate FSA ownership within a country. While

firms vary in the extent to which they locate FSA ownership in tax havens, it is important

to understand the operational antecedents of this choice.

From a managerial standpoint, the results indicate a clear association between the

characteristics of FSAs owned by the firm and the internal ownership structures used to

manage them. The different types of FSA ownership structures create different linkages

across the units of the firm in terms of knowledge flows and financial flows. The

creation and maintenance of tacit, knowledge-intensive FSAs require diverse insights and

collaboration. The finding that MNCs use shared ownership structures when their FSAs

are tacit is consistent with the idea that shared ownership structures provide better

mechanisms for coordination and knowledge transfer and are feasible to implement

within firms.

As previously mentioned, future versions of this research will incorporate several

refinements such as the “local versus global” dimension of FSAs. The present draft of

this research is limited by the fact that Sole ownership structures were only examined in

exploratory analyses. Sole structures are expected to be predictable by the interactions of

different FSA characteristics. For example, Sole ownership structures are expected to be

chosen when FSAs are codifiable and global. In such instances, Sole structures allow the

MNC parent to more tightly coordinate activities associated with codifiable but global

FSAs and transfer knowledge to diverse units within the firm. Testing this theory would

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require creating an additional “local versus global” FSA dimension. Such an approach

will be used in the refinement of this research.

A second important future refinement is to better estimate a joint model of FSA

ownership structure and the choice to use a tax haven FSA owner. The results suggest

that these two decisions are interrelated, but a much stronger set of predictors is needed

for tax haven FSA ownership. The endogeneity of these decisions creates complex

problems with regard to pinning down the underlying structural relationships between tax

haven use and ownership structure choice.

In addition to refining the current preliminary draft of this research, there are a

large number of related research questions to investigate, which should provide further

insight into MNCs’ FSA ownership structure choices. First, future research will examine

firms’ decisions to switch from one ownership structure to another. Although this is a

relatively rare event, interesting patterns appear in the switching data such as the fact that

MNCs with Shared ownership structures never switch to Separate ownership structures,

but the reverse does not apply. An investigation of structure changes is beyond the scope

of the present research.

Second, future research at the affiliate level will study the relationships between

ownership structures and flows of goods and services within the firm. Previous research

suggests that intra-firm trade is knowledge-intensive and complex to organize within

firms (Feinberg and Keane, 2006); however detailed data on transactions within MNCs

have not been previously available to researchers. Third, future research will investigate

MNC structure choices at the affiliate level. A more disaggregated investigation of FSA

ownership structures will allow for examination of the degree to which these are

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associated with location choices. Such an analysis would contribute to both the product

mandate literature and to the location choice literature. This unique data on ownership

and related transactions within MNCs can shed light on basic questions related to the

theory and management of multinational firms.

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5. Subsidiary Ownership of FSAs and Innovation

ABSTRACT

This study examines the relationship between FSA ownership and subsidiary

innovation. Innovation is inherently difficult to monitor and control. Property rights

theory suggests that ownership provides two incentives for investing in the creation of the

asset: 1) the ability to appropriate income from the innovations created, and 2) the ability

to control both the asset and its future direction of development. The results suggest that

subsidiary FSA ownership is positively associated with innovation, and that transferring

ownership away from the subsidiaries that create the FSAs has a negative effect on

innovation. I also explore the effects of having tax haven subsidiaries own the rights to

MNC FSAs and find that subsidiaries that perform activities for pure tax havens innovate

less than those contracted by the parent.

Introduction 5.1

It is estimated that the U.S. government loses over $60 billion a year in tax revenue

due to corporate tax evasion (Bloomberg, 2010). Tim Cook, the CEO of Apple,

executives from Caterpillar, Inc., Starbucks, Amazon, etc., have all been called to testify

before government bodies in the United States and abroad, regarding their companies’

use of tax havens. As noted by a Wall Street Journal article, one key mechanism through

which firms are able to avoid taxes is by transferring economic ownership of their

intellectual property to subsidiaries located in tax havens (Wall Street Journal, 2002).

For example, Starbucks’ European subsidiaries license the rights to use Starbucks brands,

products, and processes from their Netherlands subsidiary, Starbucks Coffee EMEA BV

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(Reuters, 2012). Because the Starbucks Netherlands subsidiary owns the economic rights

to Starbuck’s intellectual property, it is legally entitled to the profits from the intellectual

property. Management theorists have generally assumed that a firm’s key value

generating assets, or firm-specific advantages (FSAs) are public goods within the firm

(e.g. Ethier, 1986; Kogut and Zander, 1992). However, multinational firms (MNCs)

allocate ownership of their FSAs to subsidiaries and or the parent, who bear the risk of

developing the FSAs, maintain control rights to the FSAs, extensively contract and

license the FSAs to other entities within the firm, and receive the income or losses from

the FSAs. Subsidiary ownership of FSAs not only affects where tax payments and profits

reside within the MNC, it affects subsidiary-level control over assets and resources, and

incentives for the maintenance and creation of future FSAs. The allocation of FSA

ownership within the MNC can have important consequences for MNC innovation,

growth, and profitability. Despite its importance, relatively little is known about the

effects of the economic ownership of FSAs within the MNC. No doubt the absence of

research on this topic is mainly due to the lack of available data.

Using a new, confidential dataset on 102 MNCs and their subsidiaries, I examine

the ramifications of internal FSA ownership on subsidiary technological innovation. I

explore whether firms like Starbucks that strip FSA ownership rights from value

generating subsidiaries and give those rights to tax haven subsidiaries within the firm

creates incentive problems with regard to future innovative activity.

Subsidiaries play a key role in innovation, and it is generally to the benefit of the

MNC to allocate FSA ownership to the entity creating the FSA. Researchers have noted

the importance of foreign subsidiaries in the creation of FSAs for MNCs (e.g. Cantwell

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1995; Dunning and Narula 1995; Kuemmerle, 1997; von Zedtwitz and Gassmann, 2002).

Subsidiaries are able to draw on their diverse local knowledge, skills, and expertise to

create innovations. Subsidiaries are not just locations to tap into the local expertise, but

are hubs for value creation within the firm (Birkinshaw et al, 1998).

The ability to share and leverage FSAs across complimentary activities and

geographically dispersed locations is an advantage of the firm. With the advantage,

however, comes the organizational problem of allocating control over the assets and

structuring incentives for the ongoing creation and maintenance of the FSAs. Since the

subsidiaries that create the FSAs may be different from those that use them, MNCs face

the organizational problem of allocating the ownership rights and control to the various

profit-generating FSAs within the firm.

In an exchange relationship, the party whose activity makes the largest

contribution to the creation and maintenance of the asset should own the asset (Grossman

and Hart, 1986; Hart and Moore, 1990). Transferring FSA ownership away from value

generating subsidiaries means that the MNC is also transferring the risk and rewards of

development away from the centers of innovation within the MNC. Chapter 4 suggested

that MNCs form different internal market structures to manage the way knowledge is

created and shared within the firm. Firms face tradeoffs in choosing both the FSA

structures and FSA ownership. While reducing tax expenditures is one reason for

assigning subsidiary FSA ownership, operational factors, such as innovation activities,

subsidiary role, MNC growth, and administrative complexity are also important in

determining FSA ownership. Transferring FSA ownership within the firm is costly and is

heavily scrutinized by tax authorities. The structuring of FSA ownership involves large,

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often one-time decisions about a subsidiary owning FSAs. Because the FSA ownership

structures are long lasting and there are conflicting priorities that MNCs must balance,

some MNCs may have sub-optimal structures in place or structures that have unintended

consequences.

The purpose of this paper is to examine the effects of subsidiary-level FSA

ownership on subsidiary technological innovation. Ownership provides two incentives

for investing in the maintenance and creation of FSAs: 1) the ability to appropriate

income from the innovations created, and 2) the ability to control both the asset and its

future direction of development. Subsidiary FSA ownership is predicted to be positively

associated with innovation. As the vast majority of subsidiaries within the firm are FSA

users that are contracted by FSA owners to perform various activities, I further examine

the contracting relationships within the firm. Subsidiaries that are contracted by the

parent have increased incentives for advancement within the MNC and organizational

identification, which will motivate them to innovate. Thus, subsidiaries that contract

with the parent are predicted to be positively associated with innovation. In contrast,

subsidiaries that are contracted by pure tax haven FSA owners may become disenchanted

by having to give the fruits of their labor to another subsidiary whose activities do not

directly contribute to the development of the FSAs. Therefore, it is expected that

subsidiaries that are contracted by pure tax haven FSA owners will be associated with

reduced innovation.

To test the predictions, I compiled a subsidiary-level dataset on the economic

ownership of FSAs and subsidiary contracting and licensing relationships of 95 MNCs in

an unbalanced, panel dataset from 1997 to 2011. I combined the data with data from

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Bureau Van Dijk’s Orbis database and patent data from United States Patent Trademark

Office (USPTO). The dataset contains information on 7,156 subsidiaries and their

50,934 patents over the 1997-2011 time period. The results to the analyses suggest that

FSA ownership is important for subsidiary innovation. Subsidiaries that own the rights to

the FSAs they create are significantly more likely to produce technological innovations.

Moreover, transferring ownership away from a subsidiary significantly reduces its

innovation. While contracting with a parent is positively associated with innovation,

contracting with a pure tax haven entity has a negative effect on subsidiary innovation.

This paper makes several important contributions to the literature on the MNC and

subsidiary innovation. First, it contributes to the theory of the multinational firm by

showing how the internal governance of FSAs affects the creation of future FSAs. The

free-flow of knowledge within the firm has been held as a key advantage of the firm

(Ethier, 1986; Hymer, 1960; Caves, 1971). However, within the MNC, knowledge is

bought and sold amongst the subsidiaries and/or parent. Assigning FSA ownership

within the MNC creates internal markets for knowledge, which can enhance innovation

within the firm. Second, this research contributes to the subsidiary entrepreneurship

literature by introducing economic ownership of FSAs as a means of establishing

entrepreneurial subsidiaries within the MNC. The FSA owners bear the risk and rewards

of not just their own operations, but also of other subsidiary operations. Third, I

contribute to the literature on subsidiary innovation by examining the effects of FSA

ownership on subsidiary innovation. Although FSAs have long held a central role in the

theory of the MNC, the effects of FSA ownership on subsidiary innovation remains

unexamined. Research on subsidiary innovation focuses primarily on subsidiary

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capabilities and knowledge transfer and diffusion (e.g. Frost, Birkinshaw and Ensign,

2002; Almeida and Phene, 2004). Fourth, I go beyond transfer pricing research’s focus

on profit shifting and tax avoidance (e.g. Grubert, 2003; Mutti and Grubert, 2008;

Dischinger and Riedel, 2010) by showing how tax haven subsidiaries and FSA ownership

can affect real operations.

Contextual Background 5.2

Within the MNC, the parent and/or subsidiaries (entities) that own the FSAs (FSA

owners) internally contract other entities (FSA users) within the firm to perform activities

such as research and development, manufacturing, and distribution and pay the FSA users

a guaranteed return for their activities. MNCs use legal, written contracts between the

subsidiaries and/or parent to specify and solidify their intra-firm relationships. The

internal contracts outline the activities to be performed, the rights, risks borne, and

payment terms of the entities. Some MNCs have FSA owners that perform operational

activities, whereas others have “pure tax havens” – subsidiaries that are located in tax

haven countries, own the economic rights to FSAs, and do not perform operational

activities. The FSA owners typically maintain rights control over the use and

development of the FSAs. In the case of pure tax haven FSA owners, which tend to have

minimal employees, the parent typically controls the FSAs while the tax haven subsidiary

keeps the profits.

Before proceeding, it is useful to provide a brief example of the internal

contracting and licensing arrangements. ABC Transmissions is a transmission company

headquartered in the U.S. Its German subsidiary is the economic owner of the

transmission technology. The Germany subsidiary contracts the UK subsidiary to

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develop transmissions for small vehicles and promises to pay the UK subsidiary a 7%

mark-up on its R&D expenses. If the UK subsidiary fails to create a new product or takes

an extra two years to do so, the U.K. subsidiary still receives the 7% return on its R&D

expenses and the German subsidiary incurs the loss associated with the R&D activities.

If the UK subsidiary creates the latest and greatest new transmission, the U.K. subsidiary

continues to receive the 7% mark-up on its R&D costs. The German subsidiary, as the

economic owner, receives any income from the new transmission above what it promised

to pay the contracted subsidiaries. Once a new transmission is developed by the U.K.

subsidiary, the German FSA owner contracts the French subsidiary to manufacture the

transmissions and other foreign subsidiaries to distribute it. In effect, FSA ownership

shifts risk within the firm, in this case development risk, from the UK subsidiary to the

German subsidiary. It also shifts the rewards from innovative efforts. This creates the

classical principle agent problem within the context of the multinational firm.

Although the popular press has focused on internal contracting and licensing

associated with tax haven subsidiaries, tax havens are a subset of MNC contract and

licensing relationships. In reality, the majority of MNCs contract and license their FSAs

between the parent and/or subsidiaries that are not tax havens. The following table shows

the proportion of subsidiaries in the dataset that own the rights to FSAs.

Table 13: Breakout of FSA Ownership by Subsidiary Type

FSA

Owners

FSA

Users Total

Operational Non-Tax Haven Subsidiaries 4.9% 86.3% 91.1%

Operational Tax Haven Subsidiaries 0.5% 8.0% 8.5%

Pure Tax Haven Subsidiaries 0.3%

0.3%

Total 5.7% 94.3% 100%

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As shown in Table 13, approximately 5.7% of subsidiaries own economic rights to

MNC FSAs, and the remaining 94.3% percent either contract or license FSAs from FSA

owners. Approximately 8.5% of subsidiaries are located in OECD-classified tax haven

countries and perform operational activities, 0.5% are FSA owners. Finally, 0.3% of

subsidiaries are pure tax haven FSA owners. This means that 1) relatively few

subsidiaries within the firm own the economic rights to the FSAs they create, 2) most

FSA owners are not located in tax haven countries, and 3) while all MNCs have internal

FSA owners, the majority of MNCs do not have tax haven FSA owners.

Economic ownership of FSAs is a means of allocating authority and control within

the organization. The entities within the MNC that bear the risks associated with creating

the FSAs also receive the rewards. In a sense, the FSA owners are the “entrepreneurs” of

the MNC. They bear risk associated with the MNCs activities while insulating other

subsidiaries within the firm from risks. As owners of the MNC’s most important value

generating resources, the FSA owners are responsible for generating future FSAs within

the firm. Research on subsidiary mandates examines the determinants and consequences

of allocating to a subsidiary the responsibility of a product line or division. Economic

ownership within the firm goes one step further: FSA owners are the entrepreneurs of the

firm that own the rights to the firm’s key value generating assets. FSA owners bear the

risk of the MNCs operations and coordinate activity by licensing the knowledge assets

and contracting activities by other subsidiaries and/or the parent within the firm.

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Theoretical Background 5.3

5.3.1 MNCs and Innovation

MNC growth and profitability are based on the continuous process of generating,

developing, and implementing innovation (Buckley and Casson, 1976). Innovation is the

generation of a new idea, product, service, process, technology, or management practice

by an organization (Damanpour, 1991). While innovation occurs at the individual level,

subsidiary-level innovation is the aggregation of innovations of individuals employed at

the subsidiary location. This paper focuses on technological innovation. The literature

on the MNC broadly conceptualizes innovation to include technology, new products, new

management practices, and commercial applications of new knowledge (Buckley and

Casson, 2009). Research has shown innovation to be crucial for increasing firm market

share, profitability, and growth (Banbury and Mitchell, 1995; Cottrell and Nault, 2004;

Nerkar and Roberts, 2004; Morck and Yeung, 1991).

Early research on MNC innovation (e.g. Hymer 1976; Rugman 1981) viewed any

foreign R&D activities as ‘home-base exploiting’ (Kuemmerle, 1999) or ‘competence

exploiting’ (Cantwell, 1987), where foreign subsidiaries adapt FSAs developed by the

parent to the local host market. In the 1990’s, researchers began to view the MNC as a

network of subsidiaries that obtain and create knowledge in the local environment, and

share the knowledge across the network of subsidiaries (e.g. Bartlett and Ghoshal, 1989;

Nobel and Birkinshaw, 1998; Hedlund, 1994; Hakanson and Nobel, 1993). MNCs

establish foreign subsidiaries to draw on the local skills, knowledge, and expertise

necessary to generate FSAs. Subsidiary capabilities are generated based on the

competitive advantage of the region (Frost et al, 2002). Empirical research has shown

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that foreign subsidiaries hold an important role in product development through building

technological capabilities and absorbing local technologies and knowledge (Pearce and

Papanastassiou, 1999; Zander, 1997; Driffield and Love, 2003).

5.3.2 Difficulties of Managing Innovation

Although the MNC has access to a diverse pool of knowledge and capabilities

from its foreign subsidiaries (Zhao, 2006; Birkinshaw, 1997; Kuemmerle, 1999; Lou,

2002), MNCs are faced with the challenge of fostering innovation across their

geographically dispersed network. Innovation is inherently difficult to monitor and

control since it involves combining implicit and explicit knowledge (Osterloh and Frey,

2000) and the outcome is uncertain. Innovation requires the investment of human capital.

For innovative activities, it can be very difficult to determine whether new knowledge has

been created or whether the effort has been invested for its creation. While new

initiatives that fail are observable, the lack of action on new ideas, concepts, or solutions

is unobservable. Consequently, it is difficult to distinguish between effort and luck. As a

result, monitoring mechanisms are ill suited for innovation activities.

Investing in R&D projects can be risky and costly. Subsidiaries may not want to

devote resources to developing the MNC’s FSAs unless they are adequately

compensated. Although the parent may finance R&D activities, in such cases the

subsidiary lacks control. The incentive to invest in innovation is muted when the

knowledge created is a public good (Holmstrom and Roberts, 1998). If FSAs are pure

public goods within the firm, subsidiaries may free ride on the efforts of others, and

conflicts can emerge over the use and control of the innovations created.

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5.3.3 Property Rights Theory and Incentives

Grossman and Hart (1986) maintain that when activities are difficult to monitor

and control, asset ownership should be allocated to the entity whose contribution has the

largest marginal effect on the asset’s value. Asset ownership affects the incentives to

invest in human capital and knowledge creation (Wang et al, 2009). Because the owner

receives the excess income from the asset, ownership affects ex-ante investment

decisions (Grossman and Hart, 1986; Hart and Moore, 1990). When the asset owner is

not the entity that develops the resource, the developer has less incentive to devote the

full effort for maximizing value creation (Grossman and Hart, 1986).

Ownership provides the owners with power and control over the operations (Hart

and Moore 1990; Rajan and Zingales, 2000). The FSA owners coordinate and allocate

tasks to the non-owners. Rajan and Zingales (2000) maintain that the owners have the

power to punish the non-owners by withholding resource allocations, re-directing tasks,

and exiting businesses. The owners of the residual rights can also influence firm strategy.

Grossman and Hart (1986) provide the example of a coal boiler that has difficulty

processing impure coal. If the coal plant owner owns the coal mine, then it will direct

that the coal mine obtain better coal. In contrast, if the coal mine owns the coal plant, it

will direct that the plant technologically improve the boiler to handle the impure coal.

Ownership allows control over the solutions to problems and over the strategic direction

of future investments.

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Hypotheses 5.4

FSA ownership provides a dual mechanism for incentivizing subsidiary

innovation: 1) the ability to appropriate income from the innovations created, and 2)

private benefits of control.

Ownership of MNC FSAs will determine the incentives of the subsidiaries to

invest in MNC FSAs. Ownership encourages more relationship-specific investments

(Grossman and Hart, 1986). Since the FSA owners bear the losses associated with failed

attempts to innovate, the subsidiaries that own FSAs have a vested interest to ensure

success. For subsidiaries, increased profitability from ownership of successful projects

makes it easier to justify bonuses and salary increases. Budd, Konings, and Slaughter

(2005) note that entity profitability can help to justify large wage payments to

management and workers. By assigning FSA ownership to entities within the MNC that

have the skills, knowledge, resources, expertise, and a better understanding of the risk,

the MNC can leverage human and physical resources to enhance its ability to innovate.

The second benefit of ownership is that it confers control rights (Hart and Moore,

1990). The FSA owner has control over the strategic decisions and how to allocate the

resources related to the asset. Research on subsidiary autonomy has long held that

control increases incentives and initiative (Birkinshaw, Hood, and Jonsson, 1998). At the

subsidiary level, Mudambi et al. (2007) examine the role of self-determination of

sourcing, hiring, marketing, and product development, on knowledge generation and find

that self-determination is positively associated with subsidiary innovation. Control of

knowledge creates incentives to invest in R&D (Levin et al., 1987). In a study of market

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contracting relationships, Leiponen (2008) finds that the ability to control intangible

assets is positively associated with innovation.

In contrast, the control rights of the FSA owners blunt the entrepreneurial

incentives of the subsidiaries that are FSA users. When entities do not bear the full

effects of their decisions, they tend to underinvest due to the dissipation of benefits from

their investment (Fama and Jensen, 1983; Hart and Moore, 1990). Although the FSA

owner can delegate autonomy and decision making authority, the ability of the FSA

owner to intervene in management decisions reduces manager incentives (Aghion and

Tirole, 1997). Rotemberg and Saloner (1994) and Hart (2001) suggest that the ability of

residual rights owners to choose which ideas are implemented and to capitalize on the

benefits of the idea reduces managers’ incentives to produce valuable ideas. Stein (2001)

notes that it will discourage the entity from taking costly, non-contractible actions to

increase firm value. When the residual rights owner intervenes too often, it can stifle the

entity’s initiative (Aghion and Tirole, 1997). The owners of the control rights cannot

establish credible commitments to not intervene in delegated decision-making (Foss,

2003). Foss (2003) finds that the intervention by managers in decisions delegated to

employees dramatically reduces employee motivation. In a study on the allocation of

control rights in inter-firm exchanges of service firms, Leiponen (2008) finds that service

firms that yield control rights to clients are 20-30 percent less likely to introduce new

services.

Subsidiary FSA ownership, through the combination of the ability to appropriate

the income and control rights to the innovations they create, provides a strong incentive

for subsidiaries to innovate.

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Hypothesis 1: Subsidiary FSA ownership will be positively associated with

innovation.

5.4.1 Contracting Relationships

The vast majority of subsidiaries are FSA users contracted by FSA owners to

perform activities within the firm. Moreover, many FSA owners contract and license

FSAs with other FSA owners. This section examines the question of whether the

contracting relationships matter for subsidiary innovation.

5.4.2 Tax Haven FSA Ownership, Contracting, and Subsidiary Innovation

The ownership of assets in an exchange relationship should be held by the entity

whose investment is the most important to the generation of future value. Asset owners

over invest in the asset because they receive all of the income from any assets created

from the investment (Grossman and Hart, 1986). The non-owning entities are likely to

underinvest since they do not receive any additional benefits, over the contractual return,

from any assets or income created in the exchange. Firms will choose an optimal

ownership structure that minimizes the overall loss in surplus due to investment

distortions (Grossman and Hart, 1986). Foss and Foss (2001) propose that costly

monitoring or verification will influence who will own an asset. Particularly when non-

contractible relationship-specific investments are required, ownership should be assigned

to the entities important to the development of the asset. Consequently, FSA ownership

may be misaligned when an entity within the firm owns the FSAs but does not directly

create the MNC FSAs.

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The misalignment of ownership can reduce the incentives of the contracting

subsidiaries to invest in the asset. Roth and O’Donnell (1996) suggest that the

psychological identification of an agent with the principal is important in determining the

agency problem for global operations. Similarity of functions and reciprocity of

knowledge exchanges facilitate greater psychological identification between units. The

incentive effect on innovation activities will be particularly strong if the FSA owner does

not perform core activities. Gertner et al. (1994) note that assigning control rights to the

capital providers in an internal capital market may be costly since it diminishes

managerial incentives. Pure tax haven entities do not perform operational activities nor

do they trade with other entities. If the FSA owner performs activities that contribute to

the generation of the FSA, the FSA users may more readily concede that the cash flow to

the FSA owner is warranted. In contrast, if the FSA owner does not perform core

activities, FSA users may become disenchanted since the fruits of their labor are captured

by an entity whose activities do not directly contribute to the development of the FSAs.

The literature on internal capital markets discusses the “dark side” of resource

reallocation within the firm. Resource reallocation reduces incentives. When units differ

in resources and investment potential, resources are reallocated despite manager efforts

(Inderst and Laux, 2005). Brusco and Panunzi (2005) argue that removing the residual

income generated by a unit reduces manager incentives to generate cash flows. This

leads to smaller overall value creation and thus creates less residual income to reinvest

(Brusco and Panunzi, 2005).

Hypothesis 2: Contracting with a Pure Tax Haven FSA owner will be negatively

associated with subsidiary innovation.

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5.4.3 FSA Ownership, Contracting with Parent, and Innovation

Research on headquarter-subsidiary relations has long held that connections with

headquarters are important. The subsidiaries that contract with parent FSA owners have

direct, ongoing operational ties with the parent. These ties involve routine reporting,

regular invoices sent to the parent for activities performed, communication about

budgets, projects, and changes in operations. Managers of the contracting subsidiaries

have higher visibility with corporate headquarters, which can provide incentives of career

advancement and greater access to resources if the subsidiary performs well. Interunit

communication is important for the creation of innovations (Burns and Stalker, 1961).

Prior research has shown that communication and positive attention from the parent

increases subsidiary initiative (Birkinshaw, 1999; Bouquet and Birkinshaw, 2008).

Additionally, interactions with the parent can foster shared identity, which has

been considered necessary for motivating subsidiaries to innovate (Ghoshal and Bartlett,

1988). By sharing strategy, goals, and values with the corporate group, subsidiaries are

more likely to better understand their role in the organization and may be more

accommodating to the needs of other units, as well as motivated towards innovating for

the group (Ghoshal and Bartlett, 1988). Moreover, shared organizational identity

incentivizes knowledge sharing, which enhances innovation. Ghoshal and Bartlett (1988)

find that high levels of headquarter-subsidiary communications are positively associated

with subsidiary creation, adoption and diffusion of innovations.

Incentives for recognition, shared identity with the corporate group, and

knowledge sharing can work together to increase innovation.

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Hypothesis 3: Contracting with the Parent will be positively associated with

innovation.

Methods 5.5

The hypotheses were tested using a unique, confidential, subsidiary-level dataset

constructed from several sources. Information on MNC internal FSA ownership was

compiled from MNC transfer pricing reports from a consulting firm. In compliance with

OECD guidelines and government regulations, MNCs are required to document their

intra-firm transactions each year. The transfer pricing reports contain detailed

information on the contractual relationships between subsidiaries, including the functions

performed and risks borne by the affiliates, as well as the economic owner(s) of the FSAs

in the exchange relationship. From the transfer pricing data, I coded each subsidiary’s

functions, whether or not the subsidiary was an FSA owner, and the FSA owners with

which the subsidiary contracts. Subsidiary financial data was pulled from Bureau Van

Dijk’s Orbis database. Patent data was collected from the USPTO since it provides the

location of each inventor on the patent, making it possible to match patents to inventor-

subsidiary locations. Data for the revealed technological advantage index came from the

OECD Patent database, based on the inventor’s country location and patent industry.

Finally, market concentration data came from Compustat’s Global Vantage database.

For subsidiary patents, I searched for all granted patents assigned to each MNC or

to any subsidiary within the MNC’s group. Each patent was matched to subsidiary(ies)

based on inventor city, state, and country information and to a year based on the filing

date of the patent. A total of 50,934 patents were patented by the MNCs in the sample

over the sample period, of which 29,028 had only one inventor and 10,711 patents had

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multiple inventors from the same subsidiary location and therefore were coded to only

one subsidiary. The remaining 11,195 patents had inventors from more than one

subsidiary location and were therefore coded to multiple subsidiaries. On average,

subsidiaries in the sample applied for 0.46 patents each year.

Relying on the USPTO for patent data can lead to a bias towards U.S. MNCs and

U.S. subsidiaries. However, firms that are active in the U.S. have a strong incentive to

file for intellectual property protection in the United States. As 72 percent of the MNCs

in the dataset are U.S.-headquartered and all MNCs in the dataset have at least one

location in the U.S., the bias should be somewhat mitigated by the fact that all MNCs in

the sample have incentive to patent their innovations with the USPTO.

Although the sample size varies depending on the analysis, the following provides

an overview of the construction of the base sample. The starting sample was composed

of 28,837 subsidiary-year observations on 7,156 subsidiaries from 95 MNCs, over the

1997 through 2011 time period. The MNCs in the sample are large firms – the average

number of subsidiaries per MNC is 183. However, the mean is skewed. The number of

subsidiaries per MNC ranges from 1 to over 800 subsidiaries. All subsidiary types (e.g.

R&D, distribution, manufacturing, financial, etc.) are included in the sample since FSA

ownership may be allocated to any subsidiary and any subsidiary may patent an

invention. Merging in the market concentration index reduced the sample by 4,496

observations to 24,341 subsidiary-year observations. Missing MNC diversification data

further reduced the sample by 1,184 observations to 23,157 subsidiary-year observations

on 5,919 subsidiaries. In order to make the regressions with two-digit SIC industry fixed

effects estimable, subsidiaries in two digit industries with zero patenting were excluded

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from the sample, which reduced the sample to 21,148 observations. The final starting

sample was composed of 5,404 subsidiaries and 21,148 subsidiary-year observations.

For the regressions incorporating subsidiary-specific financial data, Orbis had

financial information on 9,987 subsidiary-year observations. Missing data were entered

from the company consolidating financial statements used for the transfer pricing reports

to avoid the unnecessary loss of observations. Consolidating financial data were used for

9,579 observations, leading to a total of 19,566 subsidiary-year observations. Including

lagged subsidiary-level financial variables reduces the sample by 6,657 observations on

4,274 subsidiaries and 14,491 subsidiary-year observations.

5.5.1 Variables

Dependent Variable

Subsidiary Innovation. Consistent with prior research (e.g. Phene and Alemeida,

2008; Ahuja, 2000; Rothaermel and Hess, 2007), total patents was used as a measure of

innovation. Total Patents was measured as the total number of successful patent

applications associated with the subsidiary’s inventors in each year. The patent filing

date was used to match the patents to years since it is closer to the timing of the invention

than the patent grant date.

Independent Variables

FSA Owner is a binary indicator equal to one if the subsidiary owns the economic

rights to the MNC’s FSAs, and zero otherwise. This measure was coded based on the

information contained in the transfer pricing reports. The transfer pricing reports

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explicitly identify the subsidiaries that are the FSA owners (See Chapter 3 for a detailed

description of the coding).1

Contract with Pure Tax Haven FSA Owner is a binary indicator set equal to 1 if

the subsidiary is contracted by or licenses FSAs from a pure tax haven FSA owner. An

FSA owner was coded as a pure tax haven FSA owner if it was located in tax haven

country and does not perform R&D, manufacturing, distribution, sales and marketing

activities, or financial trading (for banking firms). Approximately 21 percent of the

observations in the sample contract with pure tax haven FSA owners.

Contracts with Parent FSA Owner is a binary indicator set equal to one if the

subsidiary is contracted by the parent or licenses FSAs from the parent. Approximately

25 percent of the observations in the sample contract with a parent FSA owner.

Control Variables

Revealed Technological Advantage. Host country specialization in industry

domains affects the generation of new ideas and access to skilled and highly capable

workforce (Kogut and Chang, 1991; Anand and Kogut, 1997). Subsidiaries assimilate

knowledge from their host-country local environment (Kim, 1997; Kummerle, 1996;

Westney, 1992). I controlled for country-industry specialization using the Revealed

Technological Advantage index, calculated as the country’s share of patents in the focal

subsidiary’s industry divided by the country’s share of patents in all industries (OECD,

2011). The index equals zero when the country has no patents in the given industry, one

if the country has no specialization, and is greater than one if the country is specialized in

1 Ownership is also supported by real flows within the MNC, and legal, written contracts between MNC

entities.

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the industry. The mean value of this variable was 0.90. Revealed technological

advantage is expected to be positively associated with innovation.

Market Concentration. Local market competition drives the need to innovate and

is associated with high patenting activities. I control for each subsidiary’s country-

industry market competition using the market concentration index, calculated as the sum

of the portion of total industry revenues earned by the four largest firms in the industry

and country location of the subsidiary. This variable equals zero for highly competitive

markets and increases for less competitive markets. Low values represent greater market

competition, thus it is expected that this variable will be negatively associated with

innovation.

Change in Country Effective Tax Rate. In an exploratory analysis of changes in

ownership, the change in the host country effective tax rate is used as a control. The host

country effective tax rate is calculated as the total taxes paid by firms in the country,

divided by the total profit before tax of firms in the country. The change in country

effective tax rate was calculated as the current period effective tax rate minus the prior

period effective tax rate, and divided by the prior period effective tax rate. It is expected

that MNCs will transfer FSA ownership away from a subsidiary if there is a large

increase in the country effective tax rate.

GDP Growth. Since changes in FSA ownership may be due to economic

conditions, GDP Growth is included as a control using the change in gross domestic

product for each country. GDP growth is expected to be negatively associated with

changes in ownership.

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MNC Size. Innovation can be affected by the resources available for innovation

activities. Large MNCs can draw on a large set of resources and exploit scale economies

in R&D (Cohen, 2010). I control for MNC Size using as the natural log of total MNC

revenues. I rely on revenues as it is less affected by MNC strategic decisions as

investment in assets and R&D expenditures.2 I expect MNC size to be positively

associated with innovation.

MNC Average Subsidiary Size.3 It is expected that MNCs that have larger

subsidiaries will be more likely to grant FSA ownership to their subsidiaries. MNC

Subsidiary size is calculated as total MNC revenues divided by the total number of MNC

subsidiaries.

MNC Diversification. By engaging in diverse business segments, MNCs can take

advantage of economies of scope for their R&D activities (Cohen, 2010). A total entropy

diversification measure is used to capture the diversity of a firm’s activities (e.g. Bowen

and Wiersema, 2005; Palepu 1985). The variable is calculated as follows:

Total Entropy = ∑

Si represents the MNC’s share of total sales in business segment i. N represents

the total number of business segments in which the MNC operates. The measure is

calculated using the business segment information from Orbis and, in the case where

Orbis data was unavailable, from the consolidated financial data in the transfer pricing

2 In results not reported herein, I also estimated alternative specifications with MNC R&D intensity,

calculated as MNC R&D expenditures divided by MNC total revenues, R&D stock, calculated using the

perpetual inventory method of Rt+(1-d)Rt-1 where d=.15 (Hall et al 2005), and MNC assets. The

alternative analyses yielded results consistent with those contained in Table 19.

3 Since subsidiary size is directly affected by FSA ownership and is highly correlated with other variables

in the analysis, subsidiary size is excluded as a control.

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reports. This variable equals zero for single business firms and increases with greater

levels of diversification.

Subsidiary R&D Intensity. R&D expenditures represent inputs into the innovation

process. Prior research suggests that R&D intensity is significantly associated with

patents (Hall, Griliches, & Hausman, 1986; Mueller, 1966). Subsidiary R&D Intensity is

measured as the focal subsidiary’s total R&D expenditures divided by its total revenue.

Subsidiaries in the sample had an average R&D Intensity of 4.0 percent.

Subsidiary Role. Subsidiaries that perform more activities tend to be more

innovative. Consistent with prior research (e.g. Fey and Furu, 2008; Almeida and Phene,

2004), I control for subsidiary role using an index of the number of activities that the

subsidiary performs. The index is a count variable, giving a weighting of one to each of

the four functions: R&D, manufacturing, distribution, and service. The index has a value

of one if the subsidiary only performs one function and a value of four if the subsidiary

performs all four functions.

M&A. M&A is a dummy variable, equal to one if the subsidiary was acquired as

part of a merger or acquisition, and 0 if otherwise. I expect this variable to be positively

associated with FSA ownership as well as positively associated with innovation.

Industry and Year Effects. I control for industry using two-digit Standard

Industrial Classification (SIC) code fixed effects and differences in time using year fixed

effects. All independent variables are lagged by one year.

5.5.2 Estimation

A primary concern in conducting the analysis is whether the relationship between

FSA ownership and innovation is reversed. MNCs theoretically should assign ownership

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to their most capable, value generating subsidiaries. This would produce an upward bias

in the coefficient for FSA ownership in the results. Disentangling the endogenous

decision for a particular subsidiary to own an FSA from the effects of ownership on

innovation can be very difficult. To tackle the endogeneity concerns, multiple

approaches are used.

First, a negative binomial model is estimated with a pre-sample mean scaling fixed

effect to control for subsidiary-level unobserved heterogeneity in innovation (Blundell,

Griffith, and Van Reenen, 1999). Since there is a long history of pre-sample patenting

available from the USPTO (from 1975 onwards), the pre-sample average number of

patents produced by the subsidiary can be used as an initial condition to proxy for

unobserved differences, such as subsidiary capabilities, that can affect innovation

(Blundell et al. 1999; Aghion, Van Reenen, and Zingales, 2013). Second, I use

propensity score matching and match each FSA owner to a non-owning subsidiary in the

same country, two-digit SIC industry, and year, and with similar subsidiary-level and

MNC-level characteristics. For robustness, I compare the results to an instrumental

variables analysis. Finally, I explore the effects of removing ownership from a subsidiary

on that subsidiary’s innovation output. Each approach has its advantages and drawbacks.

For the baseline specification, I rely on a negative binomial model since the

dependent variable is a count variable characterized by overdispersion. The baseline

specification takes the following form:

E(Pit | Xit) = exp{β1Xi(t-1)+ β2Zi(t-1)+φj +τt }, (1)

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Where X is the set of hypothesized independent variables lagged by one year, Z is

a vector of lagged control variables, φj is a set of 2-digit industry controls, and τt is a set

of year fixed effects.

For the initial conditions specification, I include the pre-sample average number of

patents for each subsidiary (Blundell et al, 1999), calculated as the sum of successful

patents applied for over the pre-sample period, divided by the total number of years from

the first patent filing to 1996, the year before entering the sample. An advantage to using

initial conditions is that it is able to control for time-invariant, unobserved differences in

the innovative capabilities of subsidiaries. However, FSA ownership structures tend to

be stable over time, with many subsidiaries holding ownership for decades (less than one

percent of observations change in the sample). As a result, the pre-sample average

measure may pick up part of the effect of FSA ownership and create a downward bias in

the results.

The second analysis applies propensity score matching (Rosenbaum and Rubin,

1983), which has been used extensively in economics and management research.

Propensity score matching attempts to uncover the effect of the “treatment” – in this case,

FSA ownership – by comparing the group of treated firms to a control group of matched

similar firms. I match each FSA owner to a non-FSA owning subsidiary with similar

characteristics in the same country, two-digit industry, and year. Subsidiaries were

matched based on whether they were located in the same continent as their parent, the

average size of the MNC’s subsidiaries, whether or not the subsidiary was acquired,

subsidiary R&D intensity, and subsidiary role. Matching within country, industry, and

year removes the effects of unobserved country, industry and year-specific factors. The

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first stage of the propensity score analysis relies on a logit to predict FSA ownership

based on the subsidiary characteristics, and country, industry, and year matching criteria.

An algorithm is then used to match FSA owners to FSA users based on their predicted

probabilities from the logit regression. I used nearest neighbor matching, without

replacement. Only those observations on common support were included in the analysis.

In order to produce unbiased results, the characteristics of the control subsidiaries

should not be significantly different from the characteristics of the treatment subsidiaries.

Table 14 contains the results of balancing tests, which indicate that the variables

were balanced after matching. A t-test of the difference between the treated and control

groups’ patenting behavior was significant at p<.001.

Table 14: Balancing Test for Propensity Score Matched Sample

Variable Treated Control t p>t

Same Continent Unmatched 0.12 0.29 -14.19 0.000

Matched 0.12 0.13 96.10 -0.55 0.583

MNC Avg Subsidiary Size Unmatched 0.48 0.32 8.08 0.000

Matched 0.48 0.48 97.10 0.13 0.900

M&A Unmatched 0.20 0.23 -3.18 0.001

Matched 0.20 0.20 90.90 -0.23 0.821

R&D Intensity Unmatched 0.05 0.03 3.53 0.000

Matched 0.05 0.05 90.20 0.17 0.862

Role Unmatched 1.41 1.17 13.61 0.000

Matched 1.41 1.41 99.70 0.02 0.981

Revealed Technological Advantage Unmatched 0.86 0.82 2.85 0.004

Matched 0.86 0.86 97.50 0.05 0.960

Country Effective Tax Unmatched 0.22 0.23 -6.71 0.000

Matched 0.22 0.22 85.90 0.73 0.468

Market Concentration Unmatched 0.98 0.97 4.82 0.000

Matched 0.98 0.98 74.80 -1.49 0.137

Mean % Bias

Reduction

t-test

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An advantage to the propensity score method is that it is able to control for

unobserved heterogeneity based on observed characteristics. A limitation to this

approach is that to the extent that there are unobserved factors uncorrelated with the

controlled factors, the results can be biased. As robustness check, I also estimated

instrumental variables analysis using generalized method of moments for negative

binomial models and also a two stage least squares.

In an attempt to uncover the effects of a change in ownership, I exploit the 24

changes in FSA ownership in the sample. Two separate analyses are conducted. First, on

the sample of subsidiaries that sold their FSAs, I estimate the change in innovation post-

FSA ownership change. Second, I use a propensity score estimator to reweight

subsidiaries in the matched sample for the probability of having ownership removed.

Each FSA owner whose FSAs are sold to another MNC entity is matched to a “control”

FSA owner with similar characteristics in the year of change. Once the matched FSA

owner is identified, I pool all years of data on the matched control and treated

observations and estimate the probability that the subsidiary has FSA ownership

transferred away. The estimated probability is the propensity score. The characteristics

used to obtain the propensity score are the change in country effective tax rate, lagged

R&D intensity, lagged GDP growth, and country, 2-digit industry and year exact

matching. The analysis is restricted to firms that fall within common support. The

following table contains the t-tests for the differences in means of the unmatched and

matched samples.

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Table 15: Balancing Test for Change in FSA Ownership Matched Sample

Once the matched sample is obtained, the propensity score estimates are

transformed into weights (Dehejia and Wahba, 1999; Busso, DiNardo, and McCrary,

2009), by weighting each treated firm by 1/ ̂ and weighting each control by 1/(1- ̂). This

creates an estimate of the Average Treatment Effect of transferring ownership away from

the subsidiary.

Busso, DiNardo, and McCrary (2009) note that the reweighting technique has

better small sample properties than using simple propensity score matching. The analysis

Variable Treated Control t p>t

Change in Country Effective Tax Rate Unmatched 0.01 -0.01 1.48 0.141

Matched 0.01 0.03 35.70 -0.55 0.584

GDP Growth Unmatched 3.19 1.69 2.31 0.022

Matched 3.19 2.95 83.70 0.26 0.796

Market Concentration Index Unmatched 0.92 0.94 -0.45 0.651

Matched 0.92 0.92 87.10 -0.03 0.974

Subsidiary Size Unmatched 7.61 6.86 1.18 0.240

Matched 7.61 7.16 40.30 0.46 0.646

MNC Size Unmatched 13.12 13.72 -1.20 0.230

Matched 13.12 13.18 88.90 -0.11 0.913

MNC Subsidiary Size Unmatched 0.78 1.08 -0.66 0.510

Matched 0.78 1.18 -33.00 -0.90 0.374

R&D Intensity Unmatched 0.16 0.18 -0.27 0.787

Matched 0.16 0.09 -128.70 1.01 0.321

Inititial Patents Unmatched 0.69 1.07 -1.31 0.190

Matched 0.69 1.03 8.70 -1.22 0.231

Unmatched -0.25 -0.11 -0.72 0.473

Matched -0.25 -0.12 5.40 -0.79 0.438

Unmatched -0.12 -0.03 -0.45 0.652

Matched -0.12 0.01 -45.40 -0.66 0.512

Mean t-test% Bias

Reduction

Change in Patents Year Prior to Year

of Treatment

Lagged Change in Patents - Two

Years Prior to Year Before Treatment

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allows one to control not just based on time-invariant characteristics, but also for time

varying characteristics that affect selection. I estimate a negative binomial model to test

the effects of transferring ownership away from the subsidiary unit on the reweighted

matched sample and cluster the standard errors by subsidiary. Since there are few

observations of change, this analysis is considered exploratory.

Results 5.6

5.6.1 Descriptive Statistics

The following tables contain descriptive statistics and correlations for the variables

used in the analyses.

Table 16: Descriptive Statistics and Correlations for Initial Conditions Analysis

Variables Mean s.d. 1 2 3 4 5 6 7 8 9 10 11

1 Total Patents 0.38 5.20

2 FSA Owner Dummy 0.07 0.25 0.12

3 Revealed Technological Advantage 0.90 0.50 0.05 0.07

4 Market Concentration Index 0.58 0.07 -0.04 0.03 -0.05

5 MNC Size 15.69 1.81 0.07 0.03 -0.04 0.20

6 MNC Diversification 0.52 0.56 0.06 -0.07 0.04 0.09 0.39

7 Initial Conditions 0.09 0.39 0.62 0.17 0.09 -0.03 0.09 0.07

8 M&A 0.29 0.46 -0.01 0.01 0.06 0.02 0.05 0.17 0.01

9 R&D Intensity 0.04 0.20 0.06 -0.02 0.04 -0.09 -0.11 -0.04 0.13 0.03

10 Role 1.17 0.62 0.16 0.14 0.03 0.00 0.02 0.00 0.26 -0.04 0.20

11 Contracts with Parent FSA Owner 0.25 0.43 0.01 -0.11 -0.03 -0.17 -0.57 -0.21 0.05 -0.17 0.12 0.08

12 Contracts with Pure Tax FSA Owner 0.21 0.41 -0.05 -0.11 -0.03 -0.01 -0.16 0.01 -0.08 -0.08 0.02 -0.06 0.05

Number of observations=1621. Year=2006. Correlations greater than or less than 0.02 are significant at *p<.05.

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Table 17: Descriptive Statistics and Correlations for Propensity Score Analysis

On average, subsidiaries in the sample patent less than one patent a year. However, this

variable is skewed, with a long right hand tail. Approximately seven percent of

observations in the sample are FSA owners. One quarter of subsidiaries contract with

parent FSA owners and 21 percent contract with pure tax haven FSA owners. MNC

entities can contract with multiple FSA owners. Although not shown here, 55 percent of

subsidiaries contract with operational subsidiary FSA owners and 15 percent contract

with operational tax haven FSA owners. Turning to the correlations, as expected, the

initial conditions control is highly correlated with patenting (r=0.62). The largest

correlation between independent variables is between contracting with parent and MNC

size (r=-.57). Smaller firms have a larger proportion of subsidiaries contracting with the

parent. Because of the high correlation, the baseline specification for testing the

hypotheses relies on MNC diversification instead of MNC size.

5.6.2 Changes in FSA Ownership

I explore the effects of change in FSA ownership on innovation. There were 24

observations of change in the sample. As summarized in the table below, one quarter of

Variables Mean s.d. 1 2 3 4 5 6 7 8 9 10

1 Total Patents 1.17 6.52

2 FSA Owner Dummy 0.49 0.50 0.14

3 Revealed Technological Advantage 0.90 0.60 0.08 0.05

4 Market Concentration Index 0.59 0.03 -0.13 -0.01 -0.22

5 MNC Size 15.73 1.79 0.08 -0.07 -0.15 0.25

6 MNC Diversification 0.46 0.50 0.04 -0.11 0.02 0.05 0.27

7 M&A 0.22 0.42 -0.04 0.00 -0.01 0.00 0.01 0.25

8 R&D Intensity 0.06 0.31 0.03 -0.10 0.07 -0.16 -0.05 0.02 0.08

9 Role 1.48 0.78 0.22 0.02 0.05 -0.13 -0.15 0.05 -0.02 0.15

10 Contracts with Parent FSA Owner 0.14 0.35 0.01 -0.12 -0.05 -0.03 -0.40 -0.08 -0.13 0.01 0.14

11 Contracts with Pure Tax FSA Owner 0.09 0.29 -0.06 -0.13 -0.09 0.08 -0.21 0.01 -0.01 -0.01 -0.13 0.19

Number of observations=315. Year=2006.

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the changes transferred FSA ownership away from the parent, a little less than half

transferred FSA ownership away from operational subsidiaries, and approximately one

third transferred it away from tax haven units.

Table 18: Subsidiary FSA Ownership Change

Approximately 24% of the changes were transferring ownership to operational

non-tax haven subsidiaries, another 24% transferred ownership to operational tax haven

subsidiaries, 36% were transferred to pure tax haven subsidiaries, and 16% were

transferred to the parent.

The figures below display the mean number of patents and patent citations

received on those patents, respectively, for the subsidiaries over the three years pre- and

post-change.

Observations % of Total

Total Number of Changes 24

FSA Ownership Transferred Away From:

Parent 6 25%

Operational Subsidiary 11 46%

Operational Tax Haven 5 21%

Pure Tax Haven 2 8%

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Figure 11: Average Patenting and Citations of Patents for FSA Ownership Change

The data shows a marked change in the trend of patenting and patent quality in the

years after ownership is transferred away from the subsidiary. The mean number of

patents increases over time, but drops in the year that ownership is removed from the

subsidiary and continues to drop after the change. The average number of citations on

patents issued three years prior to and three years post change indicate a slight drop in

quality of patents in the year of change before realizing a steep drop in the years after the

change.

0

1

2

3

4

5

6

7

t-3 t-2 t-1 t=0 t+1 t+2 t+3

Total Patents

Total Patents

0

5

10

15

20

25

30

t-3 t-2 t-1 t=0 t+1 t+2 t+3

Average Citations

Average Citations

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5.6.3 Regression Results

Table 19: Random Effects Negative Binomial Results

Table 19 contains the results for the initial conditions and propensity score

matching analyses. Column 1 contains the basic initial conditions model, Columns 2-3

add the independent variables Contract with Pure Tax Haven and Contract with Parent,

respectively. Column 4 contains all three hypothesized independent variables. Column 5

adds the lagged endogenous subsidiary-level variables R&D Intensity and Role, which

(1) (2) (3) (4) (5) (6) (7) (8) (9)

FSA Owner Dummy 0.66*** 0.64*** 0.77*** 0.75*** 0.42** 0.39* 0.85*** 0.83** 0.85**

(0.15) (0.15) (0.15) (0.15) (0.16) (0.15) (0.25) (0.28) (0.26)

Contract with Pure Tax Haven -0.32* -0.31* -0.37* -0.39** -1.81** -1.03*

(0.15) (0.15) (0.16) (0.15) (0.56) (0.52)

Contract with Parent 0.55*** 0.55*** 0.22+ 0.04 0.52 0.28

(0.11) (0.11) (0.12) (0.12) (0.34) (0.33)

Revealed Tech. Advantage -0.02 -0.02 0.01 0.01 0.08 0.09 1.06*** 1.26*** 1.09***

(0.09) (0.09) (0.09) (0.09) (0.09) (0.09) (0.26) (0.28) (0.26)

Market Concentration -1.05*** -1.05*** -0.99*** -0.99*** -0.60* -0.60* -0.74 -1.29 -0.77

(0.27) (0.27) (0.27) (0.27) (0.31) (0.30) (0.76) (0.83) (0.77)

Initial Conditions 2.87*** 2.86*** 2.80*** 2.78*** 2.37*** 2.47***

(0.10) (0.10) (0.10) (0.10) (0.13) (0.14)

MNC Diversification 0.04 0.05 0.13 0.15 0.11 0.60* 0.56+ 0.67*

(0.09) (0.09) (0.10) (0.10) (0.11) (0.28) (0.30) (0.29)

MNC Size 0.03

(0.04)

M&A -0.16 -0.18 -0.08 -0.09 -0.13 -0.15 -0.11 0.02 -0.09

(0.11) (0.11) (0.11) (0.11) (0.13) (0.13) (0.29) (0.30) (0.29)

R&D Intensity 0.41*** 0.37*** 0.31 0.28

(0.10) (0.10) (0.22) (0.22)

Role 0.53*** 0.49*** 0.98*** 0.90***

(0.08) (0.08) (0.15) (0.16)

Industry Fixed Effects Yes Yes Yes Yes Yes Yes Yes Yes Yes

Year Fixed Effects Yes Yes Yes Yes Yes Yes Yes Yes Yes

Country Fixed Effects No No No No No No Yes Yes Yes

Constant -1.97*** -1.94*** -2.29*** -2.26*** -3.54*** -3.82*** -0.94 2.19 -0.95

(0.37) (0.37) (0.38) (0.38) (0.45) (0.74) (1.86) (1.89) (1.87)

Number of Observations 21148 21148 21148 21148 13744 14491 2490 2490 2490

Wald Chi Squared 1894*** 1912*** 1877*** 1895*** 1515*** 1544*** 208*** 174*** 211***

AIC 9321 9319 9299 9297 7528 7772 2428 2456 2427

Log Likelihood -4618 -4615 -4606 -4603 -3717 -3839 -1157 -1171 -1155

Initial Conditions

Propensity Score Matched

Sample

Robust, clustered standard errors are in parentheses. Two-tailed tests for variable coefficients. †p<.10; *p<.05; **p<.01; ***p<.001.

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can be affected by FSA ownership. Column 6 replaces MNC diversification with MNC

size. Columns 7-9 contain the propensity score matched sample results. Because

propensity score matching is based on a matched sample, the number of observations

decreases from 21,148 to 2,490. Turning briefly to the model statistics, estimations

including all independent variables have better model fits, as indicated by the lower AIC

values.

For the control variables, as expected, the initial conditions control has a strong

positive association with patenting (p<.001, Columns 1-6). Including the initial

conditions control in the model causes Revealed Technological Advantage and MNC

Diversification to become insignificant. Both Revealed Technological Advantage and

MNC Diversification are positive and significant in the matched sample analysis (p<.001

and p<.05, Column 7). Since Revealed Technological Advantage and MNC

Diversification tend to be relatively stable over time, the initial conditions control may be

capturing part of the effect of these variables. Market concentration is negative and

significantly associated with innovation, although this effect is reduced once R&D

intensity and subsidiary role are added to the models. The negative and significant

relationship indicates that when there is less local industry market competition,

subsidiaries are less likely to innovate. Surprisingly, M&A is insignificant in both the

initial conditions model and the propensity score matching model. After controlling for

factors associated with innovation, it appears that acquired subsidiaries are no more likely

to innovate than greenfield subsidiaries. As expected, subsidiary R&D intensity and role

are positive and significantly associated with patenting (p<.001, Columns 5 and 6).

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FSA ownership is positive and significantly associated with innovation across all

estimations. All columns report coefficients on FSA ownership between .39 and .85.

The results provide consistent support for Hypothesis 1. Hypothesis 2 is also supported:

Contract with Pure Tax Haven FSA Owner is negative and significantly associated with

innovation. For Hypothesis 3, the initial conditions and propensity score models provide

mixed support. The coefficient for Contract with Parent FSA Owner is positive and

significant in Columns 3-4 (p<.001). However, it becomes insignificant once Subsidiary

R&D Intensity and Subsidiary Role are added to the model. Moreover, Contract with

Parent FSA Owner is insignificant for the estimations using the propensity score matched

sample (Columns 8-9, p>.05).

To further explore the effects of FSA ownership on innovation, I examine changes

in FSA ownership. The results to the exploratory analysis of change in FSA ownership

are shown in Table 20. There were 24 instances of change over the sample window.

Lagged variables and missing data reduced the number of change observations to 21 in

the initial conditions sample. The total subsidiary-year observations for subsidiaries that

had ownership removed was 106 in the final sample. Lagged values in the first stage of

the propensity score analysis reduced the number of change observations to 16 in the re-

weighted propensity score analysis. The pooled control and treated sample for the

reweighted propensity score analysis was 159 subsidiary-year observations.

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Table 20: Results for Transferring Ownership of FSAs Away from Subsidiary

Columns 1-3 present the results for within-subsidiary change in patenting. A

negative binomial model is estimated on the sample of subsidiaries whose rights to FSAs

were sold to another unit within the MNC. The results to the reweighted propensity score

analysis are shown in Columns 4-6. Both analyses provide clear evidence of a drop in

innovation output. Across all six columns, the coefficient for post-change in ownership

(1) (2) (3) (4) (5) (6)

Post Change -0.96** -0.82* -1.44*** -1.32** -1.35** -1.32**

(0.33) (0.32) (0.36) (0.45) (0.46) (0.45)

Revealed Tech. Advantage 2.74 3.22+ 2.69 0.34

(1.99) (1.81) (1.80) (0.98)

Market Concentration -0.79 -0.63 -0.10 -8.74 -9.09 -8.74

(0.88) (0.90) (0.87) (7.70) (8.25) (7.71)

Initial Conditions 1.28+ 1.02 1.40*

(0.68) (0.68) (0.62)

MNC Diversification 0.89 1.15* 1.42*** 1.15*

(0.70) (0.51) (0.36) (0.51)

MNC Size 0.33 0.30

(0.22) (0.22)

R&D Intensity 0.48 0.11 1.53 1.75

(1.14) (0.98) (1.30) (1.78)

Role 0.86+ 0.40 0.40 0.41+ 0.43*

(0.45) (0.34) (0.41) (0.21) (0.21)

Industry Fixed Effects Yes Yes Yes Yes Yes Yes

Year Fixed Effects Yes Yes Yes Yes Yes Yes

Country Fixed Effects No No No Yes Yes Yes

Constant 2.89 3.74 8.89 7.44 7.73 7.44

(435.11) (553.44) (667.53) (6.84) (7.28) (6.83)

Number of Observations 106 102 100 159 157 159

Wald Chi Squared 171*** 175*** 141*** 360*** 469*** 346***

AIC 288 285 262 344 346 342

Log Likelihood -120 -118 -109 -150 -152 -150

Robust, clustered standard errors are in parentheses. Two-tailed tests for variable coefficients.

†p<.10; *p<.05; **p<.01; ***p<.001.

Subsidiaries with Change

Propensity Score Reweighted

Matched Sample

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is negative and significant (p<.05), suggesting that subsidiaries that have FSA ownership

transferred away produce fewer innovations.

5.6.4 Robustness Tests

Several robustness tests were undertaken to check the sensitivity of the results.

First, instrumental variables analysis was estimated on the full sample using generalized

method of moments and two-stage least squares. Two variables were used as

instruments: 1) the percentage of FSA owners in each subsidiary’s one-digit SIC industry

and country location (correlation with FSA Owner Dummy 0.44), and 2) a binary

indicator for whether the subsidiary is located on the same continent as the parent

(correlation with FSA Owner Dummy 0.12). The instrumental variables analyses yielded

positive and significant results for FSA ownership (p<.001) and contracting with a parent

FSA owner (p<.001), and negative and significant results for contracting with a pure tax

haven FSA owner (p<.001). Second, alternative controls were included in the models

such as the natural log of subsidiary revenue and MNC number of subsidiaries instead of

MNC size. Third, variables were entered into the models one at a time. These alternative

analyses yielded consistent results for the hypothesized variables as those shown in the

tables above.

Discussion 5.7

The theory of the multinational firm emphasizes the role of firm-specific

advantages in the existence of the firm and as a source of above normal returns (e.g.

Dunning, 1977; Rugman and Verbeke, 2001). The free-flow of knowledge within the

firm and the ability to leverage FSAs across the MNC’s network of affiliates are held as

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key advantages of the MNC. However, markets for knowledge exist inside MNCs. The

parent and subsidiaries buy and sell rights to the MNC FSAs. The transactions that occur

within the firm are not solely financial, they involve real activities and transfer risk,

rewards, and control within the MNC. A key finding of this research is that markets for

knowledge within the firm can enhance firm innovation.

This study draws on property rights theory to predict the effects of FSA ownership

on subsidiary innovation. Firms select organizational designs to cope with information

and knowledge problems (Holstrom and Roberts, 1998). Allocating ownership rights to

FSAs within the firm distinguishes which subsidiaries have control over the FSAs and

bear the risk and rewards of developing them. Ownership has a strong effect on the

incentives for investing by influencing the distribution of profits and control over the

asset and its future strategic uses (Grossman and Hart, 1986; Hart and Moore, 1990; Kim

and Mahoney, 2005; Whinston, 2001). I predict that while FSA ownership provides

incentives to invest in the creation of new FSAs, lack of ownership reduces such

incentives.

The dynamics of innovation within the MNC are shaped by the FSA ownership

and contracting and licensing arrangements. This research suggests that there can be

significant operational ramifications for removing ownership rights away from value

creating subsidiaries. Moreover, pure tax havens can have a negative impact on MNC

innovation. When ownership is granted to pure tax haven entities, MNCs are challenged

by not only the difficulties of managing innovation, but also the negative incentive effect

from profits going to a non-value generating unit. Subsidiary ties within the firm are

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important for knowledge sharing and innovation (O’Donnell, 2000). Pure tax haven

entities may cause a breakdown the linkages between organizational units.

This paper makes several important contributions to the literature on the MNC,

subsidiary entrepreneurship and innovation. First, it contributes to the literature on the

multinational firm and innovation by examining the role of the internal ownership of

FSAs on affiliate innovation, which has thus far been unexamined. The allocation of

ownership of FSAs has strategic ramifications on the future development of MNC FSAs.

The results provide strong support that subsidiary-level ownership of FSAs can be used

to enhance value.

Second, I contribute to the subsidiary entrepreneurship literature by introducing

economic ownership of FSAs as a means of establishing “entrepreneurial” subsidiaries

within the firm. The economic owners are the “entrepreneurs of the firm” in that they

bear the risks and reap the rewards from the MNC’s activities. In contrast to the

centralized view of parent decision making and control, a number of researchers view the

multinational firm as an interorganizational network (e.g. Ghoshal and Bartlett, 1990;

Hedlund, 1986; Gupta and Govindarajan, 1991). The network perspective assumes that

subsidiaries hold strategic roles in the development and maintenance of FSAs. Along

these lines, researchers studying subsidiary world mandates suggest that subsidiaries can

be granted global responsibility for a product line (e.g. Birkinshaw, 1996; Rugman,

1981). This study shares the view that subsidiaries can hold important roles in the

development and maintenance of FSAs and in bearing global responsibilities. However,

the activities of the FSA owner encompass contracting and licensing other entities within

the firm. In contracting others subsidiaries to perform activities on their behalf, the FSA

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owners insulate the contracted subsidiaries from risk. The FSA users do not gain from

exerting extra efforts or bear the consequence of their actions. This research suggests

that some subsidiaries may have power over others. That is, the FSA owner can

influence the mandates that are gained and lost by the FSA users within the firm.

There are several limitations to this research. First, this study is limited in that it

analyzes technological innovations using patents. Certain types of innovations are more

suitable to patenting than others, which leads to industry and firm differences in patenting

behavior. Additionally, patenting activities can be driven by firm strategies for

intellectual property management. I attempt to control for industry-level differences in

patenting behaviors using industry fixed effects. Second, this research studies

technological innovations only. Future research using measures of different types of

innovations can enhance our understanding of the effects of FSA ownership on

innovation. Third, the analysis of ownership change is limited by the small number of

observations. Care should be taken in interpreting the results until further analysis is

done.

There are a number of potential areas for future research. First, an examination of

how internal and external contract and licensing arrangements are similar to or different

from each other can enhance our understanding of the theory of the MNC. Second, there

are clear differences in knowledge sharing behaviors for FSA owners and users, as well

as for the FSA ownership structures. Future research exploring the effects of FSA

ownership on knowledge sharing within the firm can provide better insight into how

contracting relationships affect innovation.

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Curriculum Vitae

Catherine Magelssen

Rutgers University, Department of Management and Global Business

1 Washington Park, Newark, NJ 07102

1982 Born in Turlock, California.

2000 High School Diploma, Trinity Christian School, Sacramento, California.

2002 A.A. Modesto Junior College, Modesto, California.

2004 B.S. Business Administration, Haas School of Business, University of

California, Berkeley.

2004-2008 Senior Associate. The Ballentine Barbera Group, A CRA International

Company, Palo Alto/Pleasanton, California.

2014 PhD in Management, Rutgers Business School, Newark, New Jersey.

Publications and Proceedings

2008 Curd, R., Hart, R., and Magelssen, C. “Modeling Risk,” Euromoney ITR

Intellectual Property Guide.

2010 Feinberg, S., Magelssen, C., and Smith, M. “Early Adopters and Radical

Regulatory Reform in India: First in Line for Trade Protection,” Academy

of Management Best Paper Proceedings.

2012 Damanpour, F., and Magelssen, C. “Adoption Cycle of Managerial

Innovation: Effects of Innovation Social Status and Transaction Costs,”

Academy of Management Best Paper Proceedings.

2012 Damanpour, F., Chiu, H., and Magelssen, C. “Initiation, Implementation,

and Complexity of Managerial Innovation,” Handbook of Organizational

and Managerial Innovation, T. S. Pitsis, A. Simpson, and E. Dehlin (Ed.),

Edward-Elgar Press.